One of the pleasant surprises about my years writing about student loans has been seeing the general public get smarter about student debt. When I first started, it was common to see articles in the media that had flawed information about student debt. I think it is fair to say that borrowers are much better educated about many student debt issues.
Unfortunately, I came across an article this week about a football player who was still repaying student debt. With the minimum salary in the NFL just under half a million dollars per year, I thought it was interesting that such a well compensated athlete would still be carrying student loans.
The answer, according to ESPN, was very disappointing:
“Unlike many, he could have erased his debt quickly. But, after having no credit cards in college and living at home the final three years of school, he saw spacing out his loan payments as a way to build credit.”
This “hack” has been floating around for a while and it is a terrible suggestion.
Is Not Paying Off Student Debt is a Way to Improve a Credit Score?
Like many myths, this particular tip does have a basis in truth. Not paying off a student loan in full can potentially carry some credit score benefits. For borrowers, such as the cornerback in the ESPN story, a student loan may be the oldest open line of credit on a credit report. By paying off the student loan, the oldest line of credit will fall off the credit report and the score will potentially drop by a few points.
If credit score was a competition to see who had the best, this would be a sensible approach.
The reason this approach is a bad idea is that it ignores the two reasons we care about our credit score.
Why does a credit score matter?
- Bad scores can hurt job applications, rental applications, and insurance rates.
- A good score helps us save money on interest by qualifying for a lower interest rate.
- A good score helps us qualify for future lines of credit.
Many people make the assumption that because a credit score is important, each point on the credit score must likewise be important. This focus and drive to improve a credit score can be extremely useful, but it becomes dangerous at the point consumers lose sight of the reason that credit scores matter.
Why Spend Extra Money on Student Loan Interest?
For most consumers, a few credit score points in one direction or the other will not make a difference. Those with good credit can afford to drop a few points without it hurting future financial goals, and those with bad credit won’t suddenly have a good credit score if they choose not to pay off their student loans.
Ultimately, the decision for most comes down to a very simple question: would you rather save money on interest right now, or do you think having a few extra points on your credit score will make a difference?
The purpose behind chasing a good credit score is that it helps save money on interest on future large purchases. Given the minimal movement in score caused by paying off a loan, opting for the certainty of saving money right now seems smart.
Don’t Forget that Paying off Debt can Help
Most creditors look at two critical numbers when evaluating applications: credit score and debt-to-income ratio.
While the credit score may take a temporary dip when a loan is paid off, the debt-to-income ratio will certainly improve. A consumer’s debt-to-income ratio is the ratio of monthly income compared to monthly payments on their existing debt. Creditors will often deny applicants who have large monthly bills compared to what they earn. Borrowers who pay back a student loan in full will improve their debt-to-income ratio once the debt falls off the credit report.
The Exception(s) to the Rule
In most cases delaying repayment in full of a student loan in order to avoid a drop in credit score is a mistake.
However, there are a couple circumstances where this rule might not apply.
Borrowers who are buying a house and working with a mortgage company will want to carefully discuss their strategy before moving forward. On one hand, a slight drop in credit score might be an issue. On the other hand, a debt-to-income ratio improvement could mean more purchasing power. This is a question that must be answered based upon individual circumstances and an outside expert who is already familiar with your credit profile could be the best source for advice.
Another circumstance where delaying full repayment of a student loan might make sense is for borrowers who are on the fence between to financial options. Suppose a borrower is debating paying off the last $5,000 of a student loan or putting $5,000 in a retirement account. On a high interest student loan, paying off the loan is almost always the smart choice. If the student loan has a low interest rate, opting to save for retirement is probably the smart move. When the interest rate is in the middle ground it can be a more difficult decision. Borrowers in this category could use the potential credit score consequences as a tie-breaker.
Credit Age Strategy
Many student loan borrowers have credit cards that are as old or older than their oldest student loan. These borrowers really don’t need to be as concerned about any potential credit score damage from paying off a student loan.
The borrowers who do need to be concerned are those who only have a student loan on their credit report. The best thing they can do for their credit score is to open a no fee credit card as soon as possible. Whether repayment is delayed or not, the loan will eventually get paid in full. By opening a credit card account, a borrower can establish revolving credit and a positive payment history. The credit card does not need to carry a balance, it just needs to be an open account with payments made on time.
A Bird in Hand is Worth Two in the Bush
Other than a couple exceptions that have already been mentioned, it really doesn’t make sense to let a student loan linger just for the credit score benefits.
Ultimately, most people will be better off eliminating debt now and saving money on interest now. Spending extra money in the hopes that it might improve your credit score is a fool’s errand.
Take the immediate and guaranteed savings rather than hoping for a future payoff.