Student loans and credit: How does tuition debt affect your ability to borrow?

Peter Warden
The Mortgage Reports editor

In this article:

Do student loans affect your credit score? The short answer is yes. Student loans and credit have a close relationship: Tuition loans can impact your credit score in several ways:

  1. Having an installment debt can improve your mix of credit
  2. Owing a high balance can harm your utilization ratio
  3. Missing or late payments (which can happen when there are deferral issues) harm your score

In addition, the amount of debt you carry compared to your income determines how much you can afford to borrow.

Verify your new rate (May 7th, 2021)

Student loans: an exploding issue

By March 2018, around 45 million Americans owed an incredible $1.5 trillion on student loans. To put that in perspective, we owed a total of $1.0 trillion in credit and store card debt that month.

It hasn’t always been this way. Indeed, this form of debt is exploding. That $1.5 trillion was $1.1 trillion as recently as 2013.

Small wonder that some ask whether the burden of student loans is affecting how this generation of young achievers are living. For example, are those loans putting off many young, smart professionals from homeownership and buying new cars?

Are student loans stopping renters from buying?

The jury’s still out on that one. But there’s no doubt that these debts are blocking some aspirational homebuyers. This happens in two main ways:

  1. In some cases, student loans can now hurt credit scores
  2. Student debt payments make mortgage payments less affordable

Read on for more.

Student loans and credit scores

Everyone knows that making late payments hurts credit scores. Your record of prompt payments makes up 35 percent of your FICO score. (FICO is the company behind the most widely used scoring technologies.) Late payments on student loans can drop your FICO score by 60 to 110 points.

Related: First-time buyer’s guide: buying with student loans

However, your student loan can actually have a positive impact on your score. That’s because a healthy “credit mix” accounts for 10 percent of that score. A good mix is one with a balance of installment loans and revolving credit accounts, meaning:

  • Installment loans — You borrow a fixed amount and repay it over a fixed period in equal monthly installments —  like auto loans, personal loans, and student loans
  • Revolving credit — You receive a credit limit and can borrow, repay and borrow up to your limit and there is no fixed term — most credit cards are revolving accounts

If you have all plastic and no installment loans,  a student loan can improve your credit mix and boost your score.

And, of course, simply making on-time payments every month boosts lower scores and keeps great ones high.

A new threat

Until a few years ago, the last few paragraphs described the whole “student loans and credit scores” story. But then FICO released a new version of its application that introduced a fresh threat to those with student loans.

This concerns “credit utilization,” which makes up 30 percent of a FICO score.  But it’s very different from the credit utilization rules that apply to credit cards. They say you’ll be penalized if you let your card balances exceed 30 percent of your credit limits.

Don’t panic! Your score will NOT suffer until you get your student loan debt down to 30 percent of the amount borrowed. In almost all circumstances, FICO treats student loans as installment loans and credit utilization rules don’t apply.

Related: Raise your FICO 100 points in 2018 and save big on everything

But that changes if for any reason the amount you owe grows to exceed the amount you originally borrowed. This can happen with deferment and forbearance arrangements that allow you to temporarily suspend payments. Interest continues to pile on during those periods so your balance increases: possibly to 100+ percent of your original loan.

It’s then that student loans and credit scores can clash.

It’s really not clear how many borrowers are affected by this new credit utilization issue nor how severely each is impacted. FICO itself is yet to make an authoritative statement (and didn’t respond to The Mortgage Reports request for clarification) while other commentators cheerfully admit they’re largely speculating.

But most seem to think the numbers are small and the impacts on scores are typically limited.

Loan affordability and your debt-to-income ratio

If you want to borrow a significant amount, most commonly as a mortgage or auto loan, your lender will typically want to be sure you can afford the payments. And a big part of most lenders’ affordability calculation concerns the payments you make on your existing loans. The outcome of that calculation is your debt-to-income ratio (DTI).

Calculating your DTI

Here’s how that works. You add up all your monthly loan payments — minimum credit cards, student loans, auto loans, etc. — plus your prospective housing expense (mortgage principal and interest, property taxes, homeowners insurance, and HOA dues if applicable).

Divide that number by your gross (before tax) income. If you earn $4,000 a month and your new housing cost would be $1,000 a month, and your other payments total $500 a month, your DTI would be $1,500 / $4,000, or 37.5 percent.

How your DTI affects your borrowing

So you have your DTI in the form of a percentage of your gross earnings. What now?

In the US, mortgage reforms include an Ability to Repay (ATR) rule that requires mortgage lenders to loan only what you can reasonably afford to repay. Many mortgage programs limit DTI to between 36 to 43 percent, depending on your credit rating and the size of your down payment.

Related: Simple mortgage definitions: debt-to-income (DTI)

However, government-backed loans, under certain circumstances, allow DTIs as high as 50 percent. So do so-called “non-prime” lenders, which generally charge higher interest rates and require larger down payments.

You, student loans and credit

A well-maintained student loan will usually have a positive effect on your credit score. It improves your credit mix and all those on-time payments will drive your score up. It’s only if you make late payments or end up owing more than you originally borrowed that you need to worry.

It’s a different story for your DTI. Your student loan will inevitably push that up. Of course, that’s probably not a problem providing you’ve only borrowed small amounts elsewhere.

But suppose you owe a lot, to the extent your monthly debt payments are around that 40-45-percent range as a proportion of your income. You’re likely to get a better deal if you pay down some debt before you apply for a mortgage or auto loan.

Verify your new rate (May 7th, 2021)