The short answer to that question is: Just like any other line of credit affects your credit score. The long answer is: It’s complicated, and important to do correctly. As financial expert Dave Ramsey once wrote, “You can only do it once.”
All debt carries a burden and consequences, regardless of whether the subsequent credit is “good” or “bad.”
From the moment you sign a loan, your actions will have consequences. These actions will shape your credit history, and by default, your financial future.
Applying for any line of credit requires serious consideration and weighing of risks and rewards. When it comes to student loans, the stakes are even higher — without them, some students could never attend school.
Furthermore, student loans are often the first major debt young adults take on. With inexperience and prevailing financial illiteracy, mistakes often occur and naïve mismanagement can leave young adults wondering how to recover.
Because student debt is so prominent in our society, questions frequently arise when young adults begin to understand the gravity of credit and make steps toward gaining control over their financial portrait.
Are Student Loans Handled Differently Than Other Loans?
In order to understand how consolidation or refinancing any loan affects credit, it is necessary to know how credit bureaus categorize loans.
No two loans are identical, but certain loans are treated similarly based on the type of debt they incur.
The two basic types of debt are installment debts and revolving debts. Installment debts are debts such as mortgages or auto loans. Revolving debts are debts like credit cards.
Student loans fall under the category of installment debts. Therefore, the basic principles that are relevant for mortgages or car loans can be applied to student loans.
Are All Student Loans The Same?
Having multiple loans, particularly from private and federal sources, complicates the debt situation.
Because student loans are applied for on an as-need basis, when it comes time to pay off the debt, the debt is separated into payments among the multiple loans held.
Furthermore, the loans can (and likely) each carry different interest rates. Therefore, it is often prudent to begin tackling student loan debt through consolidation.
While private and federal are different types of loans, they can be refinanced and consolidated into a single loan.
However, simply because private and federal loans can be consolidated, does not mean that they should be in all situations. Federal loans almost always have better rates and terms than private loans, and once a federal loan is consolidated with a private loan, the benefits of the federal loan essentially disappear.
While private student loans may be difficult to refinance, federal student loan refinancing is available to anyone. Through the Department of Education’s government website, everyone who has a federal loan is eligible to consolidate their federal loan debts.
Therefore, the first step to address student debt is to look at the types of loans held and the consequences of consolidating them. Consolidating is often the smartest move, but in some situations, it could be more savvy to keep federal loans separated from private loans.
That being said, if multiple loans are held from the same sector, it is almost always beneficial to consolidate within the loan category (i.e., consolidating all private loans into a single loan, consolidating all federal loan debts into a single loan).
How Does Your Credit Score Handle Installment Debts Such As Student Loan Debt?
FICO — the most prevalent credit score — looks beyond just an account being paid off and closed, and delves into how the credit has been managed.
In other words, while paying off a loan is inevitably a good thing for credit scores, holding an account open and responsibly managing the debt can actually be more beneficial to your credit score than paying it all off in one lump-sum.
That being said, the positive impact of maintaining an open line of credit could be miniscule and not worth the additional interest accrued from keeping the line active. It is essential to consider the possible effects of both options before making grandiose generalizations about payments and refinancing.
Each case will be unique, but basic principles always apply.
Questions To Ask Before Consolidating
- How will consolidating change my monthly payments?
It is absolutely essential to look at the terms and conditions of possible consolidation loans to make sure the new loan is a better deal than multiple lines of credit. While having a plethora of credit lines can be detrimental to your credit, having a handful of well-managed debts can boost your score over time.
One thing to keep in mind, as your monthly payments go down, your ration of debt-to-income also goes down – this factor is particularly important as you go forward and try to open more lines of credit in the future (like mortgage loans, specifically).
- Is someone cosigning on the consolidated loan?
Consolidating private student loans can be a difficult feat, but one possible solution is to have a cosigner help shoulder the burden of the new debt. Although this is not a surefire way to get a consolidated loan application approved, it can be a beneficial tool. However, be certain both parties understand the potential consequences of having a cosigned loan.
- How many lines of credit will be affected? How many lines of credit will I have after refinancing?
If you have too many lines of credit, your credit score can go down – too many lines not managed perfectly reflects poorly on your profile as a responsible debtholder.
By having one debt for all student loans, regardless of whether the debt amount changes, your credit score can go up just based on the sheer decrease of lines open.
- By closing a line of credit, will I lose anything?
This is especially important when looking at student loans. Consolidating could mean losing borrower benefits such as student loan forgiveness, flexible payment plans and deferments.
Above all else, understand one of the largest pieces of the credit score pie is payment history. Making on-time payments regularly is one of the surest ways to ensure your credit score reflects positively on your character as a borrower.
Keep in mind debt in and of itself is not a bad thing and student loan debt in particular is not automatically a bad thing for your credit score. There are risks and rewards to every financial situation and decision made.
Understand how credit functions before jumping to conclusions. Likewise, understand every debt holder’s credit portfolio will look different and there is no one-size-fits-all solution for how to best handle debt.
As with all things financial, the more you know about options available and your particular situation, the more control you will have over your financial portrait. Your credit history is a snapshot of who you are financially.
Take the necessary time and effort to embrace your responsibility as a credit holder and make your credit work for you. Do not be held hostage by your debt; combat financial illiteracy.