Understanding Credit Scores

Bankruptcy: Bankruptcy refers to the cancellation (discharge) of all or part of a borrower’s debts. It allows borrowers who can no longer pay their debts to get a clean slate.

A borrower’s credit history tracks a record of the borrower’s past performance in borrowing money and repaying debts. The credit history includes information about the borrower’s repayment history, on-time payments, delinquencies, credit limits and the number and balances of open accounts, as well as adverse events such as defaults, bankruptcy discharges, charge-offs, repossessions and foreclosures.

A credit score is a numeric rating of a borrower’s credit history. Credit scores try to predict the likelihood that the borrower will repay his or her debts on time, as per the terms and conditions of the loan’s promissory note. The higher the credit score, the more likely the borrower is to repay his or her debts.

The FICO score from Fair Isaac Corporation is the most popular example of a credit score.  Each credit company may have a different version of the FICO score, based on differences in the credit company’s record of the borrower’s credit history.

What is a Good Credit Score?

The most widely known credit score, the FICO credit score, has credit scores that are typically on a scale from 300 to 850, with a higher score signifying a lower credit risk. A borrower with a 650 or lower credit score is considered to be subprime, representing a high risk that the borrower might be more than 90 days late on at least one debt in the next two years. Credit scores of 650 to 719 are considered to be good, 720 to 779 to be very good, and 780 to 850 to be excellent.

There are a variety of other types of credit scores that use a different numeric range. For example, the VantageScore uses a range from 500 to 990, Equifax uses a range from 280 to 850 and Experian PLUS uses a range from 330 to 830. Which credit scores are considered to be good, very good or excellent may depend on the particular type of credit score.

Experian, one of the three major credit companies, publishes national statistics concerning credit scores at www.nationalscoreindex.com. Credit scores tend to be higher for older consumers, since they’ve had more time to build good credit and are less likely to be late with payments.

How Credit Scores are Used

Lenders use the borrower’s credit history and credit scores to determine a borrower’s eligibility for a loan and the interest rate and fees that will be charged on the loan. Some lenders also reduce loan limits or restrict student loan borrowers to only direct school charges (e.g., tuition and required fees) for borrowers with lower credit scores. The process of using the borrower’s credit history and credit scores to approve a loan and set the terms of the loan is known as credit underwriting.

Private student loans base credit underwriting decisions on the credit scores of the borrower and cosigner, whichever is higher. Accordingly, a borrower with a thin (limited) or nonexistent credit history or with bad credit may still be able to qualify for a private student loan by getting a creditworthy cosigner.

Since a better credit score can typically yield lower interest rates and fees on a loan, even borrowers who could qualify for a private student loan on their own, without a cosigner, may save money by getting a creditworthy cosigner. Some lenders will even reduce the interest rate by up to 0.50% just for having a cosigner, since having two borrowers obligated to repay the debt reduces the lender’s risk.  There can be as much as a six percentage point difference between the interest rates available to borrowers with good versus excellent credit.

Borrowers with bad credit are charged higher interest rates and fees to compensate the lender for the higher risk of non-payment. For the lender to get the same total payments from a higher-risk group of borrowers, the interest rate must be much higher. For example, consider a theoretical example involving a 10-year loan with a 5% interest rate for borrowers with no risk of default. The interest rate increases to 10.1% for a group of borrowers with a 20% risk of default and to 22.8% for a group of borrowers with a 50% risk of default for the lender to get the same total payments over the life of the loan. The actual interest rates may be even higher, since the risk of default rises with increases in the monthly loan payment and increases in the interest rate lead to increases in the monthly loan payment.

Typically, lenders group credit scores into five or six tiers (ranges of credit scores). Each tier is mapped to a different set of interest rates and fees, based on the risk of delinquency and default. This introduces a set of steps into the interest rates, so that slight changes in a borrower’s credit scores can sometimes yield big changes in the interest rate and sometimes no change. Differences in interest rates are often much greater for borrowers with FICO credit scores below about 720-740, jumping by 1% to 3% from one tier to the next. Most lenders do not publish the tiering of the interest rates on their loans for competitive reasons, to prevent other lenders from undercutting them on price. But the patterns are similar.

Other Credit Criteria

Private student loan programs may also consider other credit criteria when determining a borrower’s eligibility for a student loan. The most common criteria include debt-to-income ratios, minimum income thresholds and the stability of a borrower’s income.

Debt-to-income ratios can be used to evaluate whether a borrower can afford to repay the debt. Debt-to-income ratios may be based on just student loan debt or may be based on all of the borrower’s debt, not just student loan debt. The three most common debt-to-income ratios include:

  • Debt-to-Income Ratio. This is the ratio of total student loan debt to total annual income. Generally, a student borrower with a debt-to-income ratio of 1:1 or lower can afford to repay his or her student loans in 10 years or less. (Generally, total student loan debt at graduation should be less than the borrower’s annual starting salary, the equivalent of a 1:1 debt-to-income ratio.) Likewise, parents should not borrow more for all their children than they can afford to repay in 10 years or by the time they retire, whichever comes first.
  • Debt-Service-to-Income Ratios. Debt service refers to the monthly loan payment. The debt-service-to-income ratio is the percentage of a borrower’s monthly gross income that must be devoted to repaying the borrower’s loans. A debt-service-to-income ratio of 10 percent or less is affordable, with 15 percent being the stretch limit for most borrowers. Debt-service-to-income ratios are often used with home mortgages. If a lender bases credit decisions on debt-service-to-income ratios but not debt-to-income ratios, a borrower with a high level of debt can qualify for a loan by choosing a repayment plan that reduces the monthly payment by extending the term of the loan. The amount of debt hasn’t changed, but the burden of the monthly loan payments on the borrower’s budget has decreased. Increasing the repayment term of the loan, however, increases the total interest paid over the life of the loan.
  • Debt-Service-to-Discretionary-Income Ratios. This ratio measures the percentage of the borrower’s monthly discretionary income that must be devoted to repaying the debt. Discretionary income is usually defined as the amount by which adjusted gross income (AGI) exceeds 150 percent of the poverty line. A borrower with a higher income may have much greater ability to repay debt than a borrower with a lower income, since more of the higher-income borrower’s income is discretionary.

Some lenders will provide lower interest rates to borrowers who agree to make monthly loan payments while the student is enrolled in school. This provides supplemental information that helps differentiate borrowers with similar credit scores, since some borrowers cannot afford to make loan payments during the in-school period. If a borrower stops making payments during the in-school period, it gives the lender an earlier warning signal of a borrower potentially encountering financial difficulty. This lets the lender work with the borrower sooner to help the borrower resolve problems. In a worst-case scenario, it also lets the lender cut off further loans to the borrower sooner, reducing the size of the defaulted debt as compared with defaults by borrowers who defer repayment until after graduation.

Automated Underwriting

Many lenders use automated tools to review a borrower’s credit history. Typically, this will result in very quick denials for borrowers who do not satisfy the lender’s credit criteria. Approvals take longer, since the borrower’s credit history must be reviewed by a human being not a computer before the loan may be approved.

Borrowers who are denied a private student loan through automated underwriting should ask the lender about their appeals process. Some lenders will make exceptions when the denial was due entirely to inaccurate information that has been subsequently corrected or when there are unusual circumstances, such bad credit on a joint account that predates a divorce.

Getting a Free Copy of Credit Reports

Consumers may receive a free copy of their credit reports from each of the three major credit companies once a year. These credit reports do not, however, include credit scores. The free credit reports are available online at www.annualcreditreport.com. Beware of copycat or similar sites that offer this type of service initially at no cost and, subsequently, charge a fee for various services, such as credit monitoring.

Some consumers get all three credit reports at the same time, while others get one credit report every four months. Getting credit reports every four months allows the consumer to monitor his or her credit on a year-round basis at no cost.

(Copies of credit reports with credit scores are available for a fee from Fair Isaac Corporation and each of the three major credit companies. These credit scores, however, aren’t necessarily the same as the credit scores used by lenders in making credit decisions, although the methodology is similar.)

Some credit card issuers, such as Discover, now provide FICO scores for free on monthly credit card statements.

The website www.creditkarma.com provides a free credit score, not the same as the FICO score, along with advice about improving credit scores and marketing of loans and other credit products. 

Credit Reporting Companies

The three major credit companies include:

How to Improve Credit Scores

There are no simple solutions that will quickly improve a consumer’s credit scores. It is very easy to damage a good credit history. All it takes is a single late payment on any consumer debt to damage an otherwise good credit history. Building good credit, on the other hand, takes time and long-term responsible use of credit.

According to Fair Isaac Corporation, the FICO score depends on five factors:

  • 35% payment history
  • 30% amounts owed
  • 15% length of credit history
  • 10% new credit
  • 10% types of credit used

More recent credit activity also has greater weight than older credit activity.

The key to getting a very good credit score is to consistently pay all bills, including credit card debts, utility bills, auto loans and mortgages, on time every month. Signing up for auto-debit will reduce the likelihood of being late with a payment, since the bills will be paid through an automatic transfer from a checking account or other bank account to the lender or merchant.

Disputing negative information in a credit report will not necessarily cause it to be removed if the debt can be validated by the creditor. If the debt cannot be validated, the creditor must remove it from the consumer’s credit report, per the Fair Credit Reporting Act (FCRA). Contact the credit company to determine how to dispute inaccurate data in a credit report, since the dispute procedures may vary. Be prepared to contact the lender and to provide supporting documentation demonstrating that the credit report is inaccurate. Merely asserting that the credit report is inaccurate may not be sufficient.

Instead of paying off a delinquent account in full, bring it current and keep it current. The goal is to generate as many positive reports as possible from creditors, to offset the negative information. Paying off a delinquent account eliminates the opportunities for positive reports, since maintaining a zero balance is not considered to be a positive or negative event, although the length of the borrower’s credit history has an impact.

Likewise, do not close inactive accounts. Instead, occasionally use the account to keep it active with a few transactions a year. Keeping an inactive account open also helps improve credit utilization statistics, by keeping the ratio of credit balances to credit limits low.

Do not open new accounts unless they are absolutely necessary. Having too many accounts with short credit histories can cause a decrease in the borrower’s credit scores.

When shopping for new credit, apply for the loans within a short period of time, such as just a few weeks. Such inquiries are treated as signs of shopping around behavior, with an assumption that the consumer is seeking a single loan, as opposed to multiple loans. Spreading out the inquiries over time may cause them to be treated as separate.  (Unsolicited or “soft” inquiries on a consumer’s credit report will not affect the consumer’s credit score. Inquiries that result from an application for credit, also known as “hard” inquiries, will cause a slight reduction in the consumer’s credit scores.)

Installment loans, such as student loans, auto loans and mortgages, are viewed more favorably than revolving credit, like credit cards. Having a high balance on a credit card will hurt more than having a high balance on a mortgage loan. Keep the balances on credit cards low, such as by paying off the balance in full each month.

Derogatory events, such as a bankruptcy discharge, will stay on the borrower’s credit history for 7-10 years. Eventually, these events will fall off the credit report and stop affecting the borrower’s credit scores. But, the only effective remedy is the passage of time, filled with positive credit activity.

If there is inaccurate information in a credit report because of identity theft, contact the Identity Theft Resource Center for free help in resolving the problem. Information is also available from the Federal Trade Commission and the credit companies. Also relevant are the provisions for getting an identity theft discharge of federal education loans.

The strategy of using a “goodwill letter” to get negative but accurate information removed from a borrower’s credit history only works when the negative reports are minor blemishes on an otherwise positive repayment history with the lender. A goodwill letter asks the lender to remove negative information (make a “goodwill adjustment”) because the borrower has been a good customer.

How Credit Scores are Used with Federal Student Loans

Federal student loans do not use credit scores to determine eligibility for or the cost of a loan. Some federal student loans (such as the Grad PLUS Loan and Parent PLUS Loan) do base eligibility decisions on a review of the borrower’s credit history. The interest rates and fees, however, are the same for all eligible borrowers.

Direct Subsidized and Unsubsidized Loans, Perkins Loans, and Direct Consolidation Loans do not consider the borrower’s credit history or credit scores.

Current Delinquency: A current delinquency is a recent delinquency, not a delinquency that occurs in the past. A current delinquency occurs when a borrower is past due on making a payment and has not yet cured the delinquency by making the late payment.

Grad PLUS Loans and Parent PLUS Loans do consider the borrower’s credit history (but not credit scores) when determining eligibility. The borrower of a PLUS Loan must not have an adverse credit history. A borrower is considered to have an adverse credit history if a recent credit report shows a current delinquency of 90 or more days or if the credit report includes certain negative events within five years of the date of the credit report, such as a bankruptcy discharge, foreclosure, repossession, tax lien, wage garnishment, default determination or write-off of Title IV federal education loan.

The absence of a credit history is not considered an adverse credit history. So a borrower may qualify for a PLUS Loan despite having a thin credit history.

In some circumstances, a prospective borrower may be able to qualify for a PLUS Loan by addressing a problem in the borrower’s credit report. For example, if the borrower was denied a PLUS Loan solely because of a 90-day delinquency, curing the delinquency by bring the account current may enable the borrower to qualify for the loan. The borrower should wait until his or her credit history has been updated or he or she has secured a credit-worthy cosigner before reapplying for the loan.

Repayment activity on federal education loans is reported to the major credit companies, so responsibly managing student loan payments can help students build a good credit history.

Additional Resources

Fair Isaac Corporation operates a discussion forum concerning the relationship between student loans and credit scores.

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