How to Recover From a Credit Disaster

November 21, 2014

During one of my recent conversations with an employee, he was very disturbed by how much a bad credit score has impacted his life.He said that his credit score has caused his car insurance premiums to increase, he thinks it is hindering his job search (he may have a point because it is something that employers consider) and his girlfriend does not want to become his fiancée or wife until he shows significant progress in this area. So, he was very happy to have some ideas on how to make progress on repairing what was a very broken part of his financial life. 

Speaking of seeing his credit score, he didn’t know what his was when we started our conversation. He was guessing and remembering what it was when he got declined for a car loan a few months prior to our conversation. So the first step in our conversation was for him to sign up for CreditKarma.com and CreditSesame.com so that we had a starting point.

It wasn’t a pretty sight! He had one of the lowest credit scores I have seen in a long time.
But it gave us useful information.

From there, we went to AnnualCreditReport.com and ordered (and saved as a PDF to his laptop) one of his three credit reports. (He will order the other two later, one four months from now and one eight months from now.) The credit report showed a very large number of accounts that were in collections or charged off. It also showed that every account he had was delinquent in payments. There was a lot of progress to be made in his case.

We had a “philosophical conversation” using the CreditKarma report card so that he could see the areas that comprise a credit score and he committed to making changes in the way he runs his financial life. The good news for him is that the total indebtedness was not very high, less than $20,000 including everything. The bad news is that he had no real savings to speak of and he had under $1,000 in his emergency fund, so making progress quickly looked like it was going to be hard.

Fortunately, he has been with his employer for a substantial period of time and had a substantial balance in his 401k. While it is not something I would typically recommend, a 401k loan could help him make a lot of progress quickly in an area that mattered to him. We talked about the pros and cons of a 401k loan, paying attention to the negatives.

He evaluated his options and felt that taking the loan made more sense than trying to dig out of debt bit by bit with the increased income from a recent promotion. In order to not get back to the same place but with a 401k loan, he has to make some changes to his behavior and he seems to be at a place where it’s finally important to him. I have a feeling that our next conversation will be a much happier one and when we talk, he will be more hopeful about the future.

If you are faced with a poor credit score and want to make progress toward improving it, here are some things you can do – if you want to tackle it on your own: (with some financial jargon in parentheses)

  1.  Live below your means. It sounds cliché, but most clichés exist for a reason. (Budgeting)
  2. Pay your bills and pay them on time!  (Timely payment history)
  3. Don’t allow your credit balances to exceed 25% of your credit line.  (Utilization rate)
  4. Don’t apply for more credit than you need at any given point.
  5. Pay off old charged off/collections type of accounts in order for the actual repair to begin. Once the account moves from charged off or collections to paid/closed, your credit score begins to improve.
  6. Once you have paid off a card, you can keep it open rather than closing the account. This helps in a couple areas where your score matters.  (Age of Credit and Number of Accounts)

For the employee that I talked to, even though he is taking a 401k loan to pay off all of his old debt, his score won’t improve overnight. It’s still going to take a long time to repair his credit. Getting a secured credit card, since he can’t be approved for a traditional card, will improve his payment history and if he keeps his utilization rate low, with each passing month he will be improving his score. With focus, discipline and continued efforts on being fiscally sound, he will move from having one of the worst scores I’ve seen to being able to get approved for a mortgage and for a marriage when his girlfriend eventually says yes to becoming his future wife.