When you make that last student loan payment, there are so many things to celebrate. First, you’re free of an expensive debt that has soaked up much of your income since entering the job market. Second, you now have extra room in your budget for whatever goals you want to reach next, whether that’s saving more for retirement, buying a house or upgrading your transportation.
Generally, paying off education debt is a great thing, but there are some negative side effects. They don’t outweigh the good that comes with getting out of debt, but you should be prepared for what’s coming once your student loan account closes.
When Having No Student Loans Hurts
Student loans are installment loans, meaning you make payments over a set period of time, and once the loan has been repaid (with interest), the account is no longer active. One of the main factors determining your credit score is your mix of credit accounts, and a combination of installment and revolving accounts will help your score. (Revolving accounts, like credit cards, allow you to repay your balance and borrow up to a certain limit over and over again.)
If student loans are your only active installment loans, paying them off will change your account mix. This category of your credit score shows how good you are at managing multiple accounts of varying structure at the same time, and without different active accounts, there’s no recent information supporting your ability to do so.
“If that student loan is really the only installment loan experience, by virtue of having no more active installment loans, that’s certainly going to be factored in,” said Ethan Dornhelm, principal scientist of the Scores Development Group at FICO.
The Positive Effect of Student Loans
Because going from having an active installment loan to having none is the most drastic result of paying off a student loan (as far as credit scores are concerned), that’s probably where you’ll see a hit to your credit score.
Still, you can’t lose sight of the positive impact student loans have on your credit. If you made your payments on time throughout the life of the loan, that positive payment history will have built up your credit over time and will continue to help as long as it remains on your credit report. At the same time, if that student loan has delinquency in its history, that mistake will continue to hurt your score. Isolated incidents of late payments won’t do damage for long, and all negative information on that account will age off your credit reports after seven years.
Then there’s debt usage, which usually refers to how much of your available credit you’re using. While keeping your credit card balances as low as possible is crucial to boosting your credit score, installment loans have an impact in this area, too.
“There’s this amount owed category, and it’s roughly 30% of your FICO score,” Dornhelm said. “There is a factor that goes into the score of amounts owed in installment loans.”
Obviously, when you pay off a student loan, your amounts owed goes down. Because most people pay off their loans bit by bit, the subsequent positive impact on your credit score will be gradual, but if you pay off a large chunk of debt at once, the boost may be more immediately significant.
Gerri Detweiler, Credit.com’s director of consumer education, noted another positive side-effect of paying off your student loans:
“Overall, your debt-to-income ratio improves, which helps with a mortgage.”
Even if you’re not applying for a mortgage, there’s nothing bad about having less debt.
Because credit profiles are unique, it’s impossible to predict exactly how paying off your student loans will manifest in your credit scores, but you can get a free credit report summary every month from Credit.com and see how you’re faring in each of these categories. That should give you an idea of how paying off your student loans will affect your credit, but keep in mind that your credit standing is constantly changing. The best thing you can do is regularly make payments on time and keep your debt levels low, because building good credit takes time.
More on Student Loans:
- How Student Loans Can Impact Your Credit
- Can You Get Your Student Loans Forgiven?
- Strategies for Paying Off Student Loan Debt
Image: Wavebreak Media