Paying off a big debt, like a student loan, can feel great and give you more money in your pocket every month. It is a smart financial move to pay off your student loans as soon as you are able.
Why is it then that your credit score drops when you pay off your student loan? This sounds very counterintuitive. Shouldn’t paying off debt be a good thing?
The answer is that it is wise to pay off your student loans as quickly as possible. While your credit score can dip slightly after paying off your student loan, with a healthy repayment history and no delinquencies, your score can jump right back up and have a positive impact on your credit report.
Initial Drop in Credit Score
There are a few reasons that your credit can take a temporary hit when you pay off a large debt like a student loan. One of them involves the credit utilization ratio.
A healthy amount of credit utilization is around 10% to 30%. This means that you are using this much of the credit you are offered. Any more debt than that and your credit score can go down, but any less debt than that can also drop your credit score.
When you pay off a student loan, you are using less credit. Therefore your credit utilization rate drops, which impacts your score.
Your FICO credit score is based on:
- Your payment history
- The amount you owe
- The length of your credit history
- Your credit mix
- Any new credit
Since student loans are often some of the first things you may have on your credit score, and one of the initial things you are using to build credit, it can be helpful to have them for longer to build up a credit history. These loans usually have fairly low interest rates, so if you take your time paying them off, you can extend your credit history. This means that you will pay more money in interest in the long run.
Another way that student loans can help boost your credit score is by keeping your credit file varied. Student loans, auto loans, personal loans, and home loans are all forms of installment credit, while credit cards involve revolving credit. About 10% of your credit score is related to having different kinds of credit, and closing out a student loan can make your credit report less variable.
Paying off your student loans can drop your credit score, but only a little and only for a short time. Part of the reason this happens is that it can cause a short-term instability in your credit file.
Installment loans are often fairly large, and paying them closes the account. It can take a few months for your credit to stabilize.
Checking your credit report can also temporarily drop your score, so try to not look at it for a few months after paying off your loans. Your credit score should come back up after a few billing cycles if you were good about paying your monthly payments on time.
A positive payment history on your student loans, and then paying them off, can help your credit file. If you don’t have any delinquencies on your account, paying off your student loan can positively influence your credit score for 10 years.
Building and Maintaining Good Credit
It can be tempting to hold onto your student loans for longer to avoid the temporary drop in your credit score, but in reality, this will just mean that you will pay more out of pocket overall.
Paying off your student loans can boost your credit over time and reflect positively on your credit history. Just be patient. Know that your score will take a slight drop and then come back up.
Here are some ways to protect and improve your credit score with student loans:
- Budget for and make your student loan payments a priority, and pay them off in a timely fashion. Stick to the recommended payment options. Make your monthly payments on time and in full each month during your entire loan term.
- Student loans, and especially federal student loans, have a lot of options for flexible repayment plans. Choose one that works for you. If you run into any kind of issues, talk to your lender or loan servicer about what to do before you miss or are late on a payment.
- Consider a student credit card, and keep this account open when you close out your student loan. This can show continued credit history as long as you keep your balance low and make consistent on-time monthly payments.
- Check for credit reporting errors, and know that your credit can improve even if you make a mistake. If you have negative dings on your credit score due to missed or late payments, these will generally only stay on your credit report for seven years. Delinquencies drop off after that time.
Paying off your student loan can help your credit in the long run, even if your credit score takes a slight hit in the short term. Don’t get discouraged or decide not to pay them off on time.
Your credit score will not only come back up, but it will be positively influenced by your ability to borrow and pay the funds back responsibly.