The First Step To Credit Rebuilding Is No More Debt

Posted in Credit Repair
Posted by J. Douglas Hoyes, CA, CPA, LIT, CIRP, CBV

no more debt We receive a lot of comments on our Facebook page from individuals struggling with debt who are afraid to consider something like a bankruptcy or consumer proposal because it will have a negative effect on their credit. Yes, filing bankruptcy or a consumer proposal will appear on your credit report. But so will many other bad credit activities which may be harming your credit score already including:

  • Maintaining high credit card balances relative to your limit;
  • Regularly exceeding or maxing out your credit limit;
  • Applying for multiple credit cards and loans; and
  • Having mostly credit card debt.

The truth is if you have too much debt, you probably already have poor or bad credit and it’s getting worse every day that you continue to struggle. When you have a low credit score, your credit options are limited and those options that you do have are very costly. Having to rely on loans that carry very high interest rates means that you end up using a larger portion of your income to maintain your debt payments. The result is a cash flow shortage, forcing you to turn to more credit to make ends meet. This kind of bad debt cycle is exactly the type of situation every person we talk to faces each and every day. It usually breaks when they find out they have no more debt options left.

While it may sound good to read a list about how to rebuild your credit, the steps are meaningless if you are caught in a quagmire of debt. Deal with the debt first, then begin the credit repair process.

Still not sure you believe me?  OK, let’s run through a case study. Taylor was a 40 year old, single, graphic designer. Work in her field was fun and challenging, but not necessarily steady. A few layoff periods caused her to rely on credit cards to get by, and eventually, she began falling behind on payments. After returning to work, she faced almost $23,000 in unsecured debts and a car loan:

  • Credit card A: $8,500 on $10,000 limit
  • Credit card B: $2,000 on $2,500 limit
  • Credit card C: $2,500 on $2,500 limit
  • Store card (furniture financing): $10,000 on $10,000 limit
  • Car loan: $23,000 (original $27,000 – 6 year term, 58 payments remaining)

Looking at Taylor’s situation, her credit utilization rate was 88% - way above the recommended 30%. In addition, credit card and high debt financing totaled half of all of her debt. Her credit capacity for new credit was almost nil, unless she wanted to start considering expensive alternatives like payday loans. What's worse is that her monthly debt payments were $1,190 a month using up 48% of her take home pay. It would be difficult for Taylor to lower her credit utilization rate and build a better credit profile while paying down this existing debt. No way would she be able to apply for better credit. Taylor chose to file bankruptcy even though she would have to make surplus income payments and her bankruptcy would last 21 months.

Taylor’s Credit Rebuilding Process

  1. Declare personal bankruptcy. Eliminate $23,000 in credit card and other debts. Retain her car.
  2. Make monthly bankruptcy payments of $400 for 21 months, plus maintain her car payment of $500. The result is a savings of $290 a month during this period.
  3. Set aside $100 a month of these savings in an emergency fund in the event of another temporary period of unemployment.
  4. After her bankruptcy discharge, Taylor increased her savings and was even able to start an RRSP. The elimination of her debt payments increased Taylor’s cash flow sufficiently so that she no longer relied on credit to balance her budget.
  5. Using a portion of the money she saved during her bankruptcy, Taylor applied for a $1,000 secured credit card for personal convenience and to begin the process of rebuilding her credit. She consistently paid off the full credit card balance each month, which provided future lenders a history of consistent debt payments and a low utilization rate on her new credit card.
  6. Three years after her bankruptcy was completed, Taylor also paid off her car loan. Her consistent loan payments during and after her bankruptcy also helped to rebuild her credit.
  7. Four years after her bankruptcy, Taylor was able to apply for a small RRSP loan, a further step in showing her ability to manage credit wisely.
  8. Six years after her bankruptcy was completed, the notice of her bankruptcy was removed from her credit report.

So yes, bankruptcy did remain on Taylor’s credit report for 8 years in total. However, by that time, Taylor had already rebuilt a strong credit profile, had savings in her bank account and had successfully restored her finances and credit in the event she wanted to qualify for another car loan or a mortgage in the future. It is unlikely she would have achieved those objectives any sooner while trying to pay down all of her high cost credit card debt. fresh start bankruptcy