How Does Student Loan Interest Affect Credit Health?

do student loans affect credit

Good news for college-bound students: interest rates on federal student loans are hitting an historic low. Loans issued after July 1, 2016 will drop an average of 0.5%. Reductions include:

  • Undergraduate loans: 4.2% to 3.76%,
  • Graduate student and parental PLUS loans: 6.84% to 6.31%
  • Graduate student direct loans: 5.84% to 5.31%

The reduction is a relief for students and parents who rely on loans to achieve their educational goals. That said, student debt has the potential to help or hurt your credit score; it all depends on the choices you make, and it’s important to look closely at the differences.

Student loan benefits include:

  • An established credit history. College grads with no credit history have a difficult time securing loans, approval for an apartment rental, utility service and other necessities. On the other hand, students who carry student loans have the benefit of an established credit history from the moment the debt is approved. For example, a college freshman who borrows $5,000 in federal loans will have four years of credit history when she graduates, regardless of whether she has begun repaying the interest or balance.
  • Accountability. A Lexington Law staff writer shared her experience with student loan debt, noting that while the burden hasn’t been easy, it also solidified her frugal nature. Maintaining long-term debt requires a healthy dose of accountability. Students who learn to manage their education debt are more likely to use funds wisely and shy away from unnecessary spending.
  • Access to education. The greatest benefit of student debt is access to expensive education. The average family cannot afford to pay for the costs of rising tuition and living expenses, and loans open the door to greater career opportunities and salary expectations in the future.

Student loans and interest have a few positives, but understanding the negatives is vital as well. In particular, student loan interest:

  • Accumulates over time. The primary downside to student loan debt is an accumulating balance. For example, suppose you borrow $25,000 over the course of four years at the new rate of 3.76%. According to the Department of Education’s estimate, it would take 120 fixed monthly payments of $251 to pay the total balance, which will accumulate to $30,089.

 

  • Can negatively affect debt-to-income ratio. 10 years of debt is a long-term commitment, one that could damage your chances of pursuing other goals. Although student loans aren’t likely to affect your credit utilization ratio, your debt-to-income ratio is another story. DTI ratio isn’t used in credit scoring, but it is considered by lenders when you apply for a home loan, auto financing, personal loans, and even rental agreements. Maxing out your DTI often means maxing out your income on monthly loan payments, a factor that can lead to credit damage. It also means missing out on other financial opportunities.

Finding the balance between benefit and risk is imperative as you earn an education. Begin by:

  • Borrowing only what you need. Many students end up borrowing more money than they need, either by overestimating costs, changing majors, or overspending. While it’s unwise to live close to financial strain, it’s worse to borrow money with interest attached. Take a better route by working part-time to safeguard your college income. Don’t allow loans to become your bottomless bank account.
  • Paying interest as you go. Federal and private loans both have pay-as-you-go options to reduce the risk of long-term accruing interest. For example, suppose you borrow $5,000 in private loans at a rate of 5%. Unlike most federal loans, private loans accumulate while you’re still in school. This means that you’ll graduate with an inflated debt of $6,077.53. Reduce your burdens by making small interest payment while you are still attending school. The result will help you avoid overwhelming post-grad debt and credit damage.
  • Asking for help. Paying for school isn’t an intuitive process, and there are plenty of resources and professionals to help you along the way. Talk to a financial planner and a credit repair lawyer to help you understand the implications, risks and benefits of borrowing. Don’t allow a lack of knowledge to stand between you and higher education.