Student loans and parent loans are made by the federal government and by private financial institutions such as banks and credit unions. Credit underwriting criteria for federal loans depend on the type of loan. But, private lenders always require a review of the borrower’s creditworthiness before approving a loan.
Borrowers should focus on federal loans before considering private loans. In addition to less restrictive credit requirements, federal loans offer fixed interest rates, more flexible repayment options, and potential loan forgiveness.
Many students lack the income needed to get a private student loan without a cosigner, even if they have a good credit history. For parents with weaker credit, federal loans may be the only good alternative.
Credit Requirements for Federal Loans
Credit criteria for the Federal Direct Stafford Loan and the Federal Direct PLUS Loan differ.
Subsidized and unsubsidized Federal Direct Stafford Loans are available to undergraduate and graduate students regardless of their credit history or income. Borrowers can have bad credit and still get these loans.
Federal Direct Grad PLUS Loans for graduate students and Federal Direct Parent PLUS Loans for parents do require a review of the borrower’s credit history. In order to receive a loan, an applicant generally must not have an adverse credit history. The determination of an adverse credit history is related to credit issues that have occurred within the past five years, such as a bankruptcy, foreclosure or delinquency.
Importantly, the credit review for Federal Direct PLUS Loans does not assess the borrower’s likely ability to repay the loan in the future. A low credit score or absence of a credit score does not affect eligibility for a Federal Parent PLUS loan. In addition, loan approval is not affected by the borrower’s employment history or amount of outstanding debt.
If a Federal PLUS Loan applicant is found to have an adverse credit history, the applicant may still be able to get approval. This can be done by successfully appealing the adverse credit history determination or by obtaining an endorser who does not have an adverse credit history. An endorser is similar to a cosigner and becomes responsible for the debt if the borrower fails to repay it.
Borrowers with two or more federal loans may be eligible to combine them into a Federal Direct Consolidation Loan. Applicants do not undergo a credit review, even if the set of loans to be consolidated includes a Federal PLUS Loan.
Credit Requirements for Private Loans
Applications for private student loans and private parent loans issued by banks or credit unions involve a review of the borrower’s credit worthiness. This assessment typically examines the applicant’s:
- Credit scores
- Credit history
- Debt-to-income ratio
- Employment history
- Secondary criteria
Lenders obtain an applicant’s credit scores from one or more of the three major credit bureaus: Equifax, Experian, and TransUnion. The credit scores calculated by the credit bureaus are more commonly known as FICO Scores. Credit scores may differ slightly at each bureau depending upon the information in the borrower’s credit report.
What is a good credit score? Nationally, the average FICO credit score is around 700. Among private student loan borrowers, however, the average credit score is around 780. As a borrower’s credit score increases, the borrower is more likely to be approved for a private student loan and to get a better interest rate. Lenders typically use 5 or 6 tiers (ranges of credit scores) when mapping from credit scores to interest rates.
Borrowers with a credit score under 650 are considered to be subprime and are unlikely to qualify for a private student loan without a creditworthy cosigner. More than 90% of private student loans made to undergraduate students and more than 75% of private student loans made to graduate students require a creditworthy cosigner.
Most students have a thin or nonexistent credit history. Accordingly, most private student loans are made based on the strength of the cosigner’s credit, not the borrower’s. Even if a borrower can qualify for a private student loan on their own, applying with a cosigner can lead to a lower interest rate, since a cosigner reduces the risk of default.
In addition to credit scores, lenders may review the applicant’s recent credit history. They look to see if the potential borrower has consistently repaid their debts on time. They also identify signs the applicant may have trouble paying their debts in the future. A large number of recent credit applications or maxing out existing credit lines may indicate the borrower’s finances are already stretched thin.
Lenders want to be confident the prospective borrower will have the resources to repay the new loan. A debt-to-income (DTI) ratio is often used to make this assessment. To calculate the debt-to-income ratio, the lender first adds up the applicant’s monthly debt payments. These include rent or mortgage payments, as well as auto loan and credit card payments. Alimony and child support payments are also added in. The total of these monthly payments is divided by monthly income before taxes to arrive at the debt-to-income ratio.
What is a good debt-to-income ratio? As with credit scores, lender standards vary. But one common rule-of-thumb suggests a borrower shouldn’t have a debt-to-income ratio above 36%. If an applicant’s debt-to-income ratio is above this level, they may have more trouble getting a loan without a cosigner.
Lenders prefer borrowers who have a stable employment history, who have worked for the same employer for at least 2-3 years. Job loss can trigger delinquency and default.
The tendency of recent college graduates to switch jobs every year can prevent them from qualifying for a refinance of their private student loans.
Keep in mind refinancing federal student loans means a loss in many benefits – income-driven repayment plans, any federal forgiveness programs, generous deferment options, and more.
Some lenders may also consider secondary criteria when making private student loans. Secondary criteria include the borrower’s year-in-school, grade point average (GPA), academic major and college. For example, a college senior is closer to graduating than a freshman, and thus represents less risk of dropping out. A student with a Ph.D. in computer science from an Ivy League institution is less of a credit risk than a student getting a Bachelor’s degree in underwater basket-weaving from a no-name college.
Part of the reasoning behind the use of secondary criteria is to try to predict the student’s income after graduation. Traditional credit scores are good at predicting college completion, but not as good at predicting ability to repay the debt after graduation. College is a transition from one occupation to another, which can significantly affect the borrower’s income and debt-to-income ratio.
Many Options for Borrowers without Good Credit
Federal Stafford Loans are available to all eligible students, and Federal PLUS Loans may still be available to students and parents with lower credit scores. In some cases, private loans may be obtained by those with weaker credit at higher interest rates or with the help of a cosigner.