The President announced on national television, about a month ago, that his final decision on widespread federal student loan forgiveness is coming soon.
An analysis of the financial effects of debt cancellation is provided by Travis Hornsby of Student Loan Planner.
It’s a good idea to consider the effects that a comprehensive loan cancellation might have on your credit score and your general financial situation if you’re one of the millions of borrowers waiting to discover if any of their student debt will be forgiven.
Don’t worry if your credit score slips a little
The most popular kind of loan to purchase are usually those with set, monthly payments, which means if you’ve ever looked at your credit report, you’ll find that the common kind of loan you had was a student loan. The fact that your student debt actually adds to your credit mix is a good thing. A variety of credit – including both revolving and installment credit – encourages lenders to accept the borrower because it demonstrates that the borrower is capable of managing different obligations that could arise from borrowing all kinds of money.
Thus, paying off installment debts such as student loans can actually damage your credit score as it will decrease your overall credit mix. Hornsby stresses that you need not worry, however. It’ll go back up in the coming months; you’re in no risk of your credit score plummeting indefinitely.
“Overall, loan forgiveness is a fantastic thing,” Hornsby told. “Focus on getting the loan forgiveness, and any kind of impact to your credit score is going to be insignificant.”
Hornsby noted one exception: if the time frame when student loan forgiveness happens is simultaneous with when you’re about to make a major purchase, such as a house or a car. It’s probably a wise idea to get pre-approved for a loan when you plan on financing a new vehicle or home. That way, your credit score will be the best when you apply for the loan.
In any case, your credit score will briefly be reduced in the event that student loan forgiveness ends up happening, but it will be barely altered – 5-10 points maximum.
Hornsby adds that many people pay too much attention to their credit scores when they don’t need to. In terms of student loan forgiveness, a temporary negative impact on your credit score doesn’t really matter.
The effect of student loan forgiveness on finances
Consider the impact of wiping $10,000 of student loans from your balance: that’s quite a blessing, both to your finances and your mental well-being. Those are $10,000 you are no longer responsible for and no longer have to pay.
Hornsby mentioned, though, that there are other upsides and downsides when it comes to either all or a part of your student loans being forgiven. Take a look at these considerations:
1. Decrease in Your debt-to-income ratio
Your debt-to-income ratio, or DTI, is increased by a high debt load, such as thousands of dollars in student loans. The higher your DTI, the more difficult it will be to borrow money in the future because your debts outweigh your income. In contrast, if your student loans are forgiven you will have a lower DTI, which will help you reduce the gap between your debt and income.
2. A refund may be given to you
According to Hornsby, there’s a chance that federal student loan borrowers who maintained Making payments despite the pandemic-related interest and payments freeze—which is still in effect through August 31, 2022—may be qualified for a refund after loans are cancelled.
3. You might have to pay more in taxes
There is a possibility that the amount of forgiveness of student debt will be subject to taxes. Hornsby says it depends on what type of forgiveness you receive. IDR forgiveness, for instance, has been tax-free until the end of 2025.
4. Your credit report will reflect any payment history that is negative
If you have your student loans forgiven either completely or in part, they’ll still show up on your credit report as such. If you have consistently made your student loan payments on time, then you are in good shape.
Despite this, Hornsby says there is a chance late payments and negative marks will be taken off your credit report when you forgive the loan, but that’s not guaranteed. It is common for late payments to be recorded on your credit report for seven years.
In fact, payments make up 35% of a person’s credit score, making it the most significant element. Payment histories play a very important role in determining your credit score, and a poor payment history can seriously harm your credit score.