Navigating adult life is easier with a good credit score. This three-digit number affects nearly every facet of your financial life, from paying for college, to renting an apartment, to buying a car.
In this article, we’ll go over everything you need to know about credit, focusing on how your credit score impacts your ability to get a student loan.
What is a Credit Score?
A credit score is a number that represents an individual’s creditworthiness. In other words, it reflects the willingness of a lender to trust you to pay back your debts.
Credit scores are important because lenders use them to determine whether they’ll grant you credit and at what cost. The higher your credit score, the more a lender will consider you able and responsible enough to repay your debt.
Where Do Credit Scores Come From?
There are three main credit bureaus: Experian, Equifax, and TransUnion. Each of these credit bureaus obtain individual credit information through lenders. They then keep track of all the information and store it until requested to release it in the form of a credit report.
Some lenders don’t report information to all three credit bureaus. Thus, not all three credit bureaus will have all of your financial information. This means that your credit report from Experian may look different than your credit report from Equifax, which may look different than your credit report from TransUnion…(you get the idea).
Check-in: Credit bureaus essentially keep track of your financial information. Then, when requested, they provide this information to lenders and creditors, in the form of a credit report, so they can determine your credit score and decide whether to lend to you.
Multiple Credit Reports + Multiple Scoring Models = Multiple Credit Scores
Each credit report includes information about your financial history. Lenders use this information to determine your credit score. Let’s break this down.
Lenders and creditors calculate individual credit scores through credit scoring models. A credit scoring model is a framework or equation used to calculate a credit score. There are two main credit scoring models: FICO and VantageScore. You can think of them as the Walmart and Target of the financial world – they’re similar, yet slightly different.
Let’s use an example to illustrate this concept.
If you asked 10 people to go bake a vanilla cake, they would all come up with a vanilla cake. However, each one would be slightly different. Everyone will have access to a different recipe and use slightly different ingredients to make their final product.
The same goes for lenders and creditors.
Each lender or creditor will use the information they have access to about your finances, along with the credit scoring model they prefer to use, to generate a credit score. Thus, while all lenders and creditors will generate the same final product (a credit score), it may vary based on which credit bureau they got your information from and which credit scoring model they used to calculate the score.
Currently, around 90 percent of top lenders use the FICO scoring model, while less than 10 percent use VantageScore. However, there are hundreds of credit scoring models lenders can choose from. So, you can theoretically have hundreds of credit scores.
This doesn’t mean you need to go calculate every single credit score you might have. It just makes understanding your credit score, how it’s calculated, and why it matters incredibly important.
Check-in: If this is still seeming a bit fuzzy, let’s try to put all the pieces together here. Credit bureaus collect and store information about your finances. The credit bureaus use this financial data to create a credit report that sums up your credit history. Then, when a lender wants to assess your creditworthiness, they pull information from these credit bureaus and the credit reports they generate to create an individual credit score. To create the score, they will use a credit scoring model. Different lenders will prefer different credit scoring models.
Why the Credit-Scoring Model Matters
If you checked your FICO credit score based on information from your Experian credit report, it will likely be different from your VantageScore credit score based on your Experian credit report. Even though both credit scoring models are factoring in information from the same credit report, they are two separate formulas and will thus generate different results.
When a lender wants to evaluate your creditworthiness, they will select the credit scoring model they want to use. You do not get to choose which model a lender uses. This is important to note because you may, for example, think you will qualify for a certain loan because you have a decent FICO score. But if a lender uses the VantageScore model and your VantageScore is lower, they may deem you not creditworthy enough to borrow.
So, while the bureaus collect the information and create the credit reports, it’s the lenders that choose which model they’d like to use to assess your credit. This means that the lender who issues you your student loan will probably look at a different credit score than the lender who issues you your auto loan or your mortgage.
Check-in: Okay. Let’s put this all together again. Credit bureaus collect and store information about your finances. Then, when a lender wants to assess your creditworthiness, they pull information from these credit bureaus in the form of a credit report. Lenders use the information in your credit report in combination with the credit scoring model of their choice to generate a credit score. They then use that credit score to assess your creditworthiness.
How is My Credit Score Calculated?
Your credit score is calculated using many different pieces of credit data in your credit report. This data is grouped into five categories, each of which is weighted differently. FICO, the most common credit score provider, uses the following information on your credit report to determine your FICO score.
Payment History (35%): How you’ve repaid your credit in the past
Credit Utilization (30%): How much of your available credit you’ve used
Length of Credit History (15%): How long your credit accounts have been in use
New Credit (10%): The number of credit accounts you recently opened
Credit Mix (10%): The different types of credit accounts you have
Each of these is important for a different reason.
Payment History (35%)
What it means: Your payment history shows how you’ve repaid your credit in the past. It often includes your past payments on credit cards, installment loans, auto loans, student loans, home equity loans, and mortgage loans.
Why it matters: Payment history is the most important factor in a credit score. When a lender looks at your credit score to determine whether to lend you money, they are trying to answer the question “If I give this person money, will they pay me back on time?” This helps a lender figure out the amount of risk they will take on when extending credit. Having a few lines of credit and paying them back on time can help you look more reliable to a lender.
For example, if you had 8 accounts and you had a late payment on 6 of them, your payment history wouldn’t look so great to the lender. This makes this section of your credit score very important.
Credit Utilization (30%)
What it means: Your credit utilization shows how much of your available credit – the “credit limit” – you are using. The ratio is calculated by dividing the total revolving credit you are currently using by the total of all your revolving credit limits.
For example, if you have a credit limit of $3,000, and you’ve only used $1,000 of it, you’d have a 30% credit utilization ratio.
Why it matters: Your credit usage is the second most important factor in your credit score. Lenders and creditors like to see that you are responsibly able to use credit and pay it off regularly. Experts recommend using no more than 30% of your available credit.
Length of Credit History (15%)
What it means: Length of credit history is all about how long your credit accounts have been in use. This includes the age of your oldest credit account, the age of your newest credit account, and the average age of all your accounts.
Why it matters: Length of credit history is the third most important factor in your credit score. Lenders want to know you’ve been in the credit game for a while — the longer your credit history is, the better. Having a history of responsibly paying your credit accounts shows lenders that you are capable of doing the same for them.
If you are just getting started with building your credit, this may be the area that hurts your credit score the most. Only time will be able to boost this section as you prove over time that you’re able to pay off your credit.
New Credit (10%)
What it means: New credit refers to the number of credit accounts you recently opened. When you apply for new credit, lenders will conduct a hard inquiry. A hard inquiry is essentially a peek into your credit report to examine your financial history. A hard inquiry can lower your credit score, but typically only by 0-5 points.
If you choose to accept the offer and open a new line of credit, it could also lower the average age of your total accounts. This, in effect, lowers your length of credit history and subsequently, your credit score.
Why it matters: The number of credit accounts you’ve recently opened, as well as the number of hard inquiries lenders make when you apply for credit, accounts for 10% of your credit score. Too many accounts or inquiries can indicate increased risk and hurt your credit score.
Credit Mix (10%)
What it means: Credit mix refers to the different types of credit accounts you have, including revolving debt (such as credit cards) and installment loans (such as mortgages, home equity loans, auto loans, student loans, and personal loans). Credit scoring models consider the types of accounts and how many of each you have as an indication of how well you manage a wide range of credit products.
Why it matters: Lenders like to see a healthy credit mix that shows that you can successfully manage different types of credit. People with top credit scores often carry a diverse portfolio of credit accounts, which might include a car loan, credit card, student loan, mortgage, or other credit products.
For example, responsibly managing a credit card, student loans, and a mortgage may demonstrate a significant level of responsibility in the eyes of a lender. Thus, diversifying your credit accounts can help demonstrate greater creditworthiness. It’s important to note that there is a “limit” to this, so to speak. Having 30 retail credit accounts probably wouldn’t be a great idea.
What is a Good Credit Score?
Credit scores range from 300-850. Generally speaking, FICO credit scores are ranked as follows:
- Below 630: Bad
- Between 630 and 689: Fair
- Between 690 and 719: Good
- Above 720: Excellent
It’s important to note that each student loan lender is different, and therefore, there is no “magic number” that will guarantee you a lower interest rate or better terms. However, there is a general principle for credit scores: “the higher, the better.”
Your Credit Score’s Impact on Student Loans
You don’t need to have a credit history to secure a federal student loan, however, private lenders may use your credit score to determine whether or not you’re eligible and at what terms. Most private lenders will look for a credit score of 670 or higher on the FICO scale (the one discussed above).
Your credit score will impact your ability to take out a private student loan and may also impact the interest rate assigned to that loan. Of course, over time this impacts how much you obtain in student debt and how much you pay for your education in the long run.
If you have a low credit score (or none at all), you should consider applying with a cosigner, such as a parent or guardian, who can help you qualify for a student loan with better terms. If that isn’t an option for you, there are specific private lenders that are known for lending to people with bad credit.
Final Thoughts from the Nest
While not the end-all-be-all, your credit score is an important factor in determining your ability to get a student loan. Don’t worry if your credit score isn’t up to par though, there are ways you can improve it.