Student debt forgiveness is a great way to eliminate financial obligations, but what happens to your credit score afterward? Many people think their credit score will immediately improve since the debt is gone. In reality, it’s not that simple. Forgiveness can have both positive and negative consequences.
What is a Credit Rating, and How is it Formed?
When you borrow money, the lender evaluates whether you can be trusted with money before approving the loan. This is where the credit score comes into play – it is a kind of assessment of your financial reliability. The higher your score, the easier and cheaper it will be to get loans, and vice versa. According to the Experian study, as of the third quarter of 2023, about 30% of American adults had a credit score of 669 or less, which limited their ability to take out favorable loans. Here’s how banks and other lenders calculate this mysterious “score”:
Payment History (35%)
This is the most significant indicator. The bank looks at how you paid your past loans and bills. If you always make payments on time, your rating goes up. But if you are late — even just once — it can seriously damage it. On average, if you are 30 days late, your credit rating can drop by 60-100 points. Interestingly, the higher your credit rating before the late payment, the more it can drop.
Debt (30%)
The bank considers how much you have borrowed and how you use your credit limits. If you borrow almost all the funds available to you, this is a signal to creditors: “This person is on the edge!” Use no more than 30% of the total credit limit to improve the situation.
Credit History (15%)
This is a plus if you have a long history of using credit and have always paid it off punctually. Lenders trust those who have a long history of responsible borrowing. But if your credit history is short, it will be harder for your rating to rise.
New Loans (10%)
Opening a lot of new loans in a short time can scare banks. They may think: “Is this person taking on too much debt?” So, before applying for many loans, it’s best to assess your financial stability.
Diversity of Loans (10%)
Lenders like it when you have experience managing different types of debt, from credit cards to mortgages. It shows that you are comfortable handling different types of obligations.
Impact of Student Debt Forgiveness on Credit Score
Forgiving student debt usually eases the financial burden and positively impacts one’s credit score. Although there are a few potential negative consequences, the pros still outweigh the cons.
The Pros of Debt Forgiveness
Here’s how student loan forgiveness improves your credit score:
- Reduced debt load. The biggest benefit of student debt forgiveness is that it reduces the total debt you owe. The less you owe, the better your financial situation looks. One of the main factors in your credit score is your debt-to-income ratio. The lower your debts, the higher your score.
- Freedom to manage other debts. Debt forgiveness frees up your funds. For example, instead of paying off your student loans, you can use the money to pay off your credit cards or other obligations. This helps improve your credit score and makes your finances more manageable overall.
- Positive credit history. If you made regular payments on your student loans before they were forgiven, this adds a “plus” to your credit history. Even after your debts are forgiven, your discipline in making payments will remain on your reports, creating a positive image in the eyes of future lenders.
Negative Sides of Debt Forgiveness
This is how your credit rating “suffers”:
- Loss of credit diversity. Lenders like it when you have a variety of debt — mortgages, credit cards, student loans. If the forgiven debt was your only major loan, it can reduce your “credit mix.” A smaller mix can slightly lower your credit score but rarely has a significant impact.
- Reducing your credit history. If your student loan was one of the oldest loans on your report, removing it can reduce the average age of your credit accounts. The older your credit profile, the stronger it looks. Removing older debt can lower your score, but it’s rarely a big deal in the long run.
How Can Student Debt Forgiveness Impact Other Aspects of Your Financial Life?
Not only does student debt forgiveness affect your credit score, it also impacts other aspects of your financial life:
1. Improved Cash Flow
The first and most rewarding thing that happens when you write off your debt is that you free up your money. The money you used to spend on monthly payments can now be used for other purposes:
- Start saving for emergencies or to buy a home.
- Invest in a retirement account or other long-term goals.
- Take a course, improve your skills, or invest in your business.
Example: If you pay $300 a month in student loans, that’s $3,600 a year that can be used to build an emergency fund, contribute to a retirement account, or pay off other debt.
2. Easier to Get Other Loans
Your debt-to-income (DTI) ratio improves when your student debt is forgiven. This ratio is an important factor that lenders consider when you apply for a mortgage, car loan, or personal loan. A low DTI means you can take on more debt, making it easier to qualify for larger loans on favorable terms.
How it works: If you previously spent 15% of your income on student loans, having them forgiven makes you a more attractive borrower because you have more available funds.
3. More Options to Invest
Without the pressure of monthly student loan payments, many people have more financial freedom to invest in their future. This could mean putting money into retirement accounts like a 401(k) or IRA or investing in stocks or real estate. You can focus on building long-term financial security by directing funds that would have gone toward paying off student debt.
4. Increased Financial Stability
Student debt forgiveness provides more than just financial relief — peace of mind. With fewer financial obligations, you have a better buffer against unexpected expenses or emergencies. This can greatly improve your overall financial stability, giving you flexibility in the event of economic or personal hardship.
5. Taxes
It’s important to remember that student debt forgiveness sometimes has tax implications. In some cases, forgiven debt is considered taxable income, which may increase your taxes in the year the debt is forgiven.
Final Thoughts
Debt relief frees up funds that were previously spent on monthly payments. Now, you can use this money for other important purposes: buying your own home, starting to invest, or creating an emergency fund.
But it’s important to remember that debt relief isn’t just about the joy of being free of obligations. It can affect your credit score, and this requires careful consideration. When you get rid of debt, your debt levels go down, but your credit activity may also decrease, which isn’t always good for your score.