You’ve finally paid off that pesky student loan that has been hanging over your head since wrapping up your degree, and now what? While a celebration is certainly in order for your big achievement, it’s time to look at how that accomplishment could impact your credit score.
What we’ll explore:
- The types of things that impact your credit score
- How paying off a student loan can change your credit score
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What affects your credit score?
Let’s quickly refresh on what your credit score is and what it is made up of. Your credit score is like your report card on your financial health. It is the scorecard that major financial institutions use to decide if you are worth loaning money to and lenders use to decide if you’re worth renting an apartment to. The higher the score, the better.
Great, so how do I obtain an A+ credit score?
Credit scores are impacted by a variety of factors, and these factors can cause the score to go up or go down. The main factors impacting your score are the following:
1. Payment history
Payment history is a record of the payments you have made to lenders over time. Consistent and timely payments on your credit cards, student loans, or any other outstanding debt contribute the greatest to your payment history and the health of your credit. The longer your timely payment history, the better for your credit score. No late payments!
2. Credit utilization
Credit utilization is the measure of how much of your total available credit you are using. “Total credit” refers to the amount of revolving credit you have available at your disposal.
How is credit utilization calculated? For example, if you have 3 credit cards, and each have credit limits of $10,000, $15,000, and $20,000, respectively, your total available credit would be $45,000. Credit utilization is expressed as a percent, and a general guideline is that your utilization should be no more than 30%. This would mean that in our example, you are using less than $13,500 of the $45,000 of credit you have at your disposal. The lower your utilization %, the better for your credit score.
3. Credit history
Credit history is the record of all of the interactions you have had with lenders over time and how you paid back those borrowings. The longer your credit history, the better. While it may be tempting to close old credit card accounts or credit cards you no longer use, if it’s an old credit card account with no annual fee, it could be more advantageous to keep this account open. Older credit card accounts show that you have a longer credit history which is beneficial to your credit score.
4. Recent credit inquiries
Frequent hard inquiries can negatively impact your credit score by a few points. But, what’s a hard inquiry? A hard inquiry occurs when you apply for a new form of credit (such as a loan or credit card), and the person or company you are borrowing from formally requests (or “inquires”) about your credit history. Companies inquire about your credit history to better understand how well you’ve paid back previous loans and use this information to decide how much they are willing to loan to you and at what interest rate.
Having multiple hard inquiries in a short period of time can be an indicator of concern for a lender.
5. Mix of accounts
The different types of credit you have at your disposal is your credit mix. A healthy credit mix is one with a variety of different accounts that include both installment debt, such as your car loans, mortgage, or student loans, as well as revolving debt like your credit card.
Credit scoring institutions, such as TransUnion, Equifax, or Experian, use the information above to calculate your credit score. This is the information that appears in your credit report and it is updated regularly based on reporting from the banking and financial institution you transact with.
Now that we’ve refreshed you on the different ways your credit score can be impacted, let’s go back and look at how paying off student loans impacts your credit score.
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How does paying off student loans affect my credit score?
Your credit score may temporarily dip when making that final student loan payment because your credit mix has changed.
Let’s explore what this means and how it happens.
As we mentioned above, consistent and timely payments, as well as credit risk (remember the 30% general rule), are factors that can impact your credit score. So, as you consistently pay off your student loans each month, those timely payments help your credit score in that you are both paying an installment loan on time and you are contributing to the mix of your accounts.
Then comes the time that you finally pay off that last piece of your student loan, and you are debt-free with a fantastic education! Success, now my credit score should be soaring! Well…not so fast…
While you are correct in thinking that paying off your student loan is a success, your credit score may not be soaring quite as high immediately following the payoff. Once your student loan debt has been completely paid off and you close your account, your credit score may temporarily dip, and here’s why:
Your credit mix has changed
Once your loan is reported as paid off, that installment loan is no longer part of your credit mix. Remember the importance of a mix of credit, it should include both installment and revolving debt. If your student loan was your only form of installment debt, and now you only have revolving debt left (such as a credit card) or you don’t have any revolving debt, your credit mix has changed, and this could temporarily lower your score.
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In conclusion, keep making timely payments on your student loans
The largest contributing factor to your credit score is your payment history. While you may be disappointed to learn that your credit score may temporarily dip when you finally pay off your student loan balance, that dip doesn’t have to be forever.
By making timely and consistent payments to your student loans throughout the life of the loan, this contributes positively to your payment history and thus, improves your credit score. So keep paying off those loans, don’t let a temporary dip in your credit score discourage you!
And to address the change in credit mix, if you don’t already have a credit card or form of revolving debt, now could be the time to consider obtaining one. This can help improve your credit mix and credit utilization which are two of the main factors which impact your credit score.
Friendly reminder that it’s important to know your score! See our post here about where you can go to get a copy of your credit report and track your credit score.