How Student Loans Affect Your Credit Score

What I learned was that while paying off student loans early may, in some cases, reduce your credit score, the advice to "be careful about paying off early" is a little misguided.
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One of the most common pieces of advice I hear about student loans and credit scores is "be careful about paying off your loans too early because it might lower your credit score." This always sounded a little odd. When I was considering whether to repay my student loans more quickly than required, I wondered at this advice and really wanted to understand why that might be the case. So I did a little research -- including a wild Saturday night poking around on the FICO Banking Analytics blog -- asked some of my very intelligent colleagues about it, and started monitoring my credit. (I use CreditKarma because it pulls out the key factors that affect my credit, and it's free.)

What I learned was that while paying off student loans early may, in some cases, reduce your credit score, the advice to "be careful about paying off early" is a little misguided. In fact, I'd go as far as to say that concern for your credit score should almost never prevent you from paying off your loans early, and paying early is likely to improve your score in some cases.

I think it is worth taking a minute to explain a little about credit scores in general. The most widely known credit score is what is known as a FICO score. It is determined by a formula created by Fair Isaac Corporation from data provided by the three major credit bureaus: Experian, TransUnion, and Equifax. Each of the bureaus provides different data, so you really have three different FICO scores -- one using data from each bureau -- that can vary.

Why share all this confusing nonsense about credit scores and bureaus? I refer you back to my wild Saturday night where I stumbled across something from the FICO Banking Analytics blog. The people who calculate the most widely used credit score write "I'd like to set the record straight on exactly how student loan debt is factored into the FICO® Score."

Ooh, tell me more.

"A student loan receives no special treatment by the FICO® Score; it is treated like any other installment loan."

Oh... so it's basically just like financing a fridge with equal monthly payments? A large, intangible, expensive fridge?

FICO: "Yeah, a fridge." (Now I'm paraphrasing.)

So, if that's the case, how and why would paying off an installment loan early adversely affect your credit? The answer is this: what is considered by FICO, and many other credit scores, is the diversity of your credit. Generally, your score is improved by having multiple types of credit, such as credit cards and different kinds of loans. So if the only installment loan you have is a student loan (which is the case for many student loan borrowers) and you fully pay off your student loan, then you have reduced credit diversity by eliminating that type of credit. This, as far as I can tell, is the only way in which paying off a student loan early adversely affects your credit.

And so, if people are right in saying that paying off early can reduce your credit score, why do I say that shouldn't really matter? The most important factors used to determine your credit score include a good payment history, how much you currently owe, the length of your credit history, and a lack of derogatory marks such as defaults or bankruptcy. Furthermore, according to FICO, the factor of "types of credit used" only accounts for roughly 10 percent of the score, whereas "amounts owed" corresponds to roughly 30 percent. While no one knows exactly how these factors affect your score, based purely on this statement from FICO, the total amount of debt is a more important factor. Credit diversity is just one factor and certainly not the most important one. So we're not talking about a 200-point dip in your score for paying off your student loans early.

Meanwhile, if you are in a position to pay off your student loans, you're looking at saving on interest payments. I can't speak for every situation, but I would think those savings are worth whatever impact on your credit score that removing loans from your credit diversity might have. And consider what you're preserving a credit score for in the first place. You're trying to give yourself the best options financially. Your credit score is only a part of that and certainly smaller than what you're actually spending and saving.

I suppose there could be corner cases where paying a little extra on your student loans for one month could help you get a lower mortgage rate, but that's a pretty specific niche. And certainly doesn't justify a generalization like "don't pay off your student loans early because it hurts your credit score."

Before I wrap up, I can't fail to mention two more points I discovered. The first is that a student loan deferral or forbearance will not adversely impact your FICO score. So it is always worth exhausting options such as deferral or forbearance with your lender in order to avoid default and damage to your credit score. The second is that while the FICO score is the most common "credit score," different lenders may use other scores or even have their own models to check credit. Therefore, my advice may not apply to every kind of credit score. However, FICO remains the most used and is often a good indicator for other scores.

My hope is that, rather than being worried about your credit score, you know enough about how it works to consider it a part of your holistic financial picture. You shouldn't categorically avoid taking any action because it may lower your credit score. In fact, if you did, you'd never apply for any kind of credit due to the adverse (and mostly negligible) effect of a hard credit check, and the score would be useless to you anyway. I'll say again that I think you should almost never hesitate to pay down student loans early because it might impact your credit. I certainly won't bat an eyelash when I have that opportunity because I believe a potential impact on my credit score will be outweighed by saved interest and the satisfaction of fully paying off my student loans.

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