The Impact of Loans on Your Credit
By Joe Messinger, CFP®
October 18, 2019
So much depends on your credit score. Credit scores are used by lenders like banks, credit card companies, mortgage lenders, and credit unions. In addition to those, credit scores are checked by landlords, cell phone companies, insurance companies, and utilities. All these companies are trying to determine if you are a good risk. Will you pay your bills on time? How low (or high) should the interest rate be that they charge you? Because this score can matter to our financial lives, the impact of loans on your credit needs to be understood.
Credit scores and your credit report are all about your history.
Institutions like the ones we mentioned use your past to predict your future. Your FICO® score…is a three digit number usually ranging between 300 to 850 and is based on metrics developed by Fair Isaac Corporation. The higher the number the more credit trustworthy you are believed to be. There are three major credit agencies in the United States: Equifax, Experian, and TransUnion. Factors that determine your score include:
- Payment history
- The amount you owe
- The length of your history
- The types of accounts you have
- Any recent activity
The goal in determining a good credit score isn’t to be debt free necessarily but to make your payments on time and have a nice long history.
Teenagers need to understand credit too.
An obvious teaching moment revolves around a teen’s cell phone. Those phones are a lifeline to them. If they were unable to pay their bill in the future or their credit history kept them from getting a phone plan, they will be keenly aware of the consequences–they don’t get a phone!
Each parent can consider whether or not to get their child a low limit credit card. They can learn how to responsibly use a credit card to make smart purchases that they can afford to pay off right away. The card and smart use of it will help them start a good credit history. Starting younger will give them a longer history. They can be taught the impact of interest rates, and the dangers that come with careless spending.
The majority of students are not learning about credit and other financial topics at school. Parents need to be their teachers.
How does borrowing to pay for college impact your scores?
Healthy credit scores have a good mix of different types of loans–10% of the score comes from the credit mix. Types of loans can include credit cards, home mortgages, car loans, student loans, etc.. The goal is to have a mix, and a student loan can be part of that mix.
Payment history makes up 35% of the credit score. Each time a payment is late or missed the credit score is negatively impacted. How many days was the payment past due? How many separate times was the payment late? If a payment is paid each and every time by the date it is due, then the credit score goes up.
Federal student loan payments will begin 6 months after graduation. Private loans can start right away. Regular, on-time payments can build a strong history over a nice length of time so that by the time the student is in their thirties, they have done the positive things to raise their credit score and buy a house for a lower interest rate.
Could having student loan debt be good for you?
Well, kind of. A student loan that is paid regularly over a nice length of time can raise a graduate’s credit score. However, the danger lies in borrowing more than can be paid back. If the monthly payment is too high, late or missed payments will drag that rating down. In addition if a payment is too high, it will negatively affect the debt to income ratio lenders use when figuring out how much money they can lend you. They’re looking at how much of your monthly income is already headed out the door.
If a payment is more than 30-days past due, the lender will report it to the credit rating companies. The drop in rating can stay on your credit report for seven years. Multiple missed or late payments will only make the problem worse.
Parents who are co-signers on a student loan need to be aware that those loans will impact their credit score too. If their name is on the loan, they are impacted. It doesn’t matter who is making the payments.
Understanding the impact of loans on your credit is important.
Your credit score and credit history will follow you throughout your adult life. It will determine whether or not you can borrow money for a home or car, and it will determine how much you will pay for that home or car. Make sure you understand how your financial decisions impact your financial future.
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