Will Paying Off Student Loans With an Inheritance Hurt Your Credit Score?
Key Takeaways
- If you pay off your student loans, your credit score might go down a little. Fortunately, the dip is temporary.
- For most people, saving a fortune in interest and improving your debt-to-income ratio is far more important than worrying about a few points of your credit score.
If you’re like this letter writer, and you’ve come into a large sum of money, you might be thinking about paying off your debts, like your student loans. Even though you’d be freed from monthly payments and save potentially thousands of dollars in future interest, you might worry that it could backfire.
You may have heard a story about someone’s credit score dipping after they paid off their loan—and maybe it’s making you think twice about paying off your own loans early.
The truth is, there’s no need to worry. According to TransUnion, one of the three credit reporting bureaus, your credit score won’t change that much, and if it does change, the change will be temporary. Ultimately, the change will pale in comparison to the long-term financial benefits of carrying less debt.
What Happens to Your Credit Score When You Pay Off Student Loans
So why would your credit score change, exactly? Well, when you pay off a student loan, the lender closes your account. This closure changes your credit mix and lowers the average age of your active accounts.
Credit scoring models tend to reward borrowers who successfully manage different types of debt over long periods. So if your student loan was your only installment debt or you’d been paying it off for many years, closing the account can cause your score to dip.
The good news, again, is that any change is usually minor and temporary. Plus, the average length of your credit history doesn't immediately change, according to Experian, another credit reporting bureau. If you close the account in good standing—that is, it isn't past due when you close it—the account will remain on your credit report for a decade. If it is past due when you close it, it will remain on your credit report for seven years.
Most important, the factors that have the most influence on your credit score—payment history and amounts owed—aren’t harmed by paying off your student loan early. You'll still have your track record of paying off your loan diligently over time.
Why Paying Off Student Loans Can Be a Smart Move
Getting your student loan balance(s) to zero comes with various benefits:
- It improves monthly cash flow.
- It eliminates future interest, which can save you thousands of dollars.
- It lowers your debt-to-income ratio, which matters if you’re looking to get a mortgage, refinance your mortgage, or borrow money for other reasons.
- It reduces your financial stress and simplifies your finances.
These advantages easily outweigh the possibility of experiencing a temporarily lower credit score.
How to Use an Inheritance Strategically
To decide what to do with your inheritance, consider how much you received and your personal circumstances. Think carefully about your future needs, avoid impulsive spending, and consult with a professional so you can understand the tax implications.
Financial advisors generally recommend paying off your debt first. Start with the debt with the highest interest rate, such as credit cards, and then build an emergency fund so you don’t end up paying for unexpected expenses with a credit card. Once your finances are in order, begin investing in future goals, like retirement.
If your inheritance is large enough, and you've paid off your high interest debt first, you may be able to pay off your student loans, or at least a portion of them.
Tip
You can try the debt snowball strategy, tackling the loan with the lowest balance first to get it paid off quickly and build some momentum. Or you could use the debt avalanche strategy, paying off your loans from highest interest rate to lowest.
Either way, prioritize any student loans that have interest rates that are higher than the returns you could reasonably expect to get from investing.