Credit is a valuable tool, but as with all tools, you must learn to use it carefully and responsibly. This means, above all, paying close attention to your credit report.
A credit report is a record of your credit history as reported to credit bureaus by your bank, credit card companies, department stores, and other businesses you’ve borrowed from. Potential lenders use the information in your credit report to decide whether they want to take the risk of issuing you credit. If you understand how credit reports work, you can protect your rights and avoid being taken advantage of by unscrupulous credit repair clinics and so-called credit doctors.
Your Rights about Credit
Under the Fair Credit Reporting Act, you have specific rights related to your credit report. You can read about these rights on the Federal Trade Commission’s (FTC) website at www.ftc.gov.
If you’re thinking about buying a house or applying for credit for any other big purchase, you’ll need a good credit report. It’s always best to know what’s on it before your lender does, so you’ll have an opportunity to clean up any discrepancies or errors.
Your credit report includes the following basic personal information:
The credit history section includes information about each credit account, including the date opened, credit limit or loan amount, balance, monthly payment, and your payment pattern during the past several years. Bankruptcies, accounts sent to collection agencies, unpaid child support or alimony, tax liens, car repossessions, court records of tax liens and monetary judgments, and the names of businesses or individuals who have obtained a copy of your credit report are also included. In addition, your report contains information obtained from public records, such as your job history, whether you own your home, and whether you’ve filed for bankruptcy. When issues between you and a creditor can’t be resolved, the comments and explanations you’re allowed to add to your credit report and the creditor’s response to your statements become part of your credit report. If an account was turned over to a collection agency, your report will include it as a “collection account” until it’s paid in full; then it will be noted as a “paid collection” and will stay on your credit report for seven years from the date of the first missed payment.
Financial advisors recommend that you obtain a copy of your credit report at least once a year and review it carefully. The Fair Credit Reporting Act allows you to get one free credit report from each credit reporting company every year. If you’ve been turned down for credit, housing, or employment because of information in your report, you may be entitled to an additional free copy of your credit report. Some states require that credit bureaus provide free copies or charge a reduced price for residents of that state, so you may find a variety of ways to get more than one free credit report per year from each of the credit reporting companies.
As mentioned previously, there are three main credit bureaus: Equifax, Experian, and TransUnion. Because some creditors report to only one of the bureaus, the information in your credit report may differ somewhat from one bureau to the other; experts recommend that you obtain a copy of your report from each of the three major credit bureaus once a year.
To order your credit reports use the official site created by the three major credit reporting companies: www.annualcreditreport.com. If you use a different site, it’s likely that you won’t get your credit reports for free. Many imposter sites claim to offer free reports and credit scores, but they will want a fee from you sooner or later, or they might just be phishing for your personal information.
If you find an error in your credit report, send a letter to the credit bureau explaining the error in as much detail as possible. You can find sample letters on the Consumer Financial Protection Bureau (CFPB) website at www.consumerfinance.gov. Provide any documents that help prove your statements. Send everything certified mail, return receipt requested. If you don’t get an answer within forty days or so, follow up with them.
What’s Not in Your Credit Report
Your credit report does not include information about your race or national origin, religion, personal lifestyle, political affiliation, medical history, criminal record, or other information unrelated to your credit history and ability to repay debt.
Lenders use the information in your credit report to evaluate your debt capacity, your collateral, your capital, and your expected ability to repay the debt. Their evaluation of your payment probability is partly based on the stability of your employment and residency history. To evaluate your debt capacity, lenders look at your open credit limits, current debts, and other payments to get a sense of how much debt you can afford based on your income and credit burden. They’re more likely to extend you credit that’s secured by collateral. For example, the car you purchase is the collateral for your car loan. If you default on the loan, the car can be repossessed, so there’s less risk to the lender. Down payments also work in your favor, as the lender can see that you have planned for and invested in the purchase.
Increasingly, lenders have been making their lending decisions by focusing on your credit score, which is a number indicating how likely you are to make payments on time and repay loans. The score is computer-generated and largely based on your use of credit in the past—how long you’ve used credit, how much you use, and how responsibly you’ve used it. All in all, they may look at your income, education, job stability, how often you’ve moved, whether you own your own home, how often you take out cash advances, how close you are to your credit limits, how many credit cards you have, and past payment history. A computer compares this information to patterns from thousands of other consumers and predicts your level of credit risk.
Many banks and credit card issuers offer free credit score tracking as part of their service; you can find the score on your monthly statement or by going online and logging in to your account. Many websites also offer free credit score tracking, but you need to watch out for scam artists who are just trying to collect your personal information. Reliable sites for this include Credit Karma, Credit Sesame, and NerdWallet. Many money management apps (like Mint) also keep track of your credit score. While there are several different credit scoring models out there, the FICO (Fair Isaac Corporation) credit score is most often used by lenders and others. All three major credit bureaus offer this option with your credit report or as a separate option.
Keeping track of your credit score can motivate you to improve it. Some of the best ways to improve your credit include paying every bill on time every month, keeping credit card balances below 30 percent of your available credit, avoiding the closure of unused credit cards and the opening of new credit cards, and checking your credit report for any inaccuracies.
When you’re ready to start paying down your debt, make a plan that you can stick to. The best plans involve focusing on one debt at a time (your “focus” debt). When you zero in on a single debt, it’s easier to make and see progress. Plus, it’s much less stressful to face a molehill than a mountain.
The two most popular paydown plans are the snowball method and the avalanche method. Either will help you dig your way out of debt, so choose whichever feels more comfortable for you. Avalanche normally works a little bit faster and saves you a little more interest. But it’s usually easier for people to stick with the snowball method because there are more victories early on.
Both methods work well, and you don’t have to lock yourself in; you can switch between them whenever you want. The trick for success here is to pick the one you think will be easier to start with, and then get started.
Whichever method you go for, make sure to do these four things:
That last point is important. Any skipped or late payments will be hit with expensive penalties that take your debt in the wrong direction and make it even harder to pay down. Avoid even the possibility of late payments by setting up automatic payments to cover the minimum for every credit card, including the focus debt.
There is a fifth thing to do, but this one can be extra tough: Stop using your credit cards except for actual emergencies. It’s practically impossible to pay credit card debt off if you’re adding new charges every month.
With the avalanche method, you’ll rank your credit card debts by interest rate, from highest to lowest, and focus on the most expensive debt first. Regardless of how big that debt is, you’ll save money in interest, which leaves more money for paying down the balance.
You can find your current credit card interest rates (sometimes listed as APR) right on the statements. Pick the card with the highest rate, and start paying that one down as fast as you can. Once it’s paid off, you’ll move to the next highest rate, and keep going until all the cards are paid off.
If you like extra encouragement and motivation, the snowball method may work well for you. Using this plan, you’ll pay down your first focus debt more quickly, and get a sense of accomplishment as you cross it off the list. You’ll be able to clearly see your progress, and that little rush (it’s true; it’s science) will help keep the paydown practice going.
With this method, you’ll list your debt in order of balance, from lowest to highest. Your smallest debt will be your first focus debt. Once that one’s settled, you’ll use the money you’d been putting toward it to pay the next debt on your list (your payments will “snowball”). You’ll keep paying off debts and moving down the list until all the debts are paid off.
Most 401(k) plans include a loan feature that allows you to borrow money from your retirement account and repay it in five years or less at an interest rate determined by your plan administrator, usually a couple of points above the prime rate. Each plan can set its own limits on the amount you can borrow, but most follow IRS guidelines. Under the CARES Act of 2020, you can borrow up to $100,000 from your 401(k) account. Plus, the CARES Act also extends the payback period: Any loan payments that would be due by December 31, 2020, can be delayed for up to one year (interest will still accrue and increase the loan balance during that time). Though this might seem like a good source of funds to use for everyday expenses or to pay down your debt, it comes with some significant drawbacks.
Your 401(k) and Debt
Using your 401(k) to pay off debts can threaten your financial future. Your 401(k) is there to support you during retirement. If you start pulling out that money now, you will end up with less money in retirement, when it’s harder to borrow, cut costs, and find work.
Taking money out of your 401(k) account could have a significant impact on your retirement income even if you pay the money back. That’s because you have less money invested to earn interest, dividends, and capital gains. Also, many employers won’t allow contributions while there’s a loan outstanding. Even if your loan is repaid in one year with interest, going that long without making new contributions will have a long-term impact on how much you accumulate by the time you reach retirement age.
Perhaps even worse than reducing the potential accumulation of earnings is the danger of being stuck with a loan balance if your employment terminates, whether it’s because you’ve accepted a job elsewhere or you were fired or laid off. If you have an outstanding loan at the time your employment ends, you’ll have to pay it back in full by the due date of your next tax return. If you don’t, the loan will count as an early withdrawal, subject to income taxes and a 10 percent early withdrawal penalty.
Let’s say you borrowed $12,000 and repaid $2,000 before changing jobs. Your loan balance at termination is $10,000. If you can’t come up with the money to repay it by the due date of your next tax return, it will be considered a premature withdrawal. If you’re in the 22 percent tax bracket, you’ll have to pay $2,200 in income taxes, plus another $1,000 (10 percent) early withdrawal penalty. All of a sudden your low-interest loan doesn’t look so good. On top of that, if you have no other way to come up with the money to pay the taxes and you have to take them from your 401(k) plan too, that money will also be subject to taxes and penalties. Either action could decimate the retirement fund that you’ve worked so hard to build.
If you start searching for help in your struggle to get out of debt, you’ll find a lot of websites offering credit counseling and loan consolidations, but not all of them will be working in your best interests. The right professionals will help you improve your money management skills. They’ll come up with realistic, workable solutions for paying off your debt and will give you solid guidance on other financial matters (like improving your credit score). Anyone who asks you to just turn everything over to them, promises to “fix” your situation, or seems uninterested in helping you figure out how to manage your financial situation is not the right help.
If dealing with your debt is more than you can handle on your own, consider working with a credit counselor. Reputable credit counselors will help you create a realistic debt repayment plan and show you ways to avoid taking on any new debt. They work with you to come up with an amount you can realistically afford to pay each month. They will talk with your creditors and get them to accept alternative payment terms that your budget can handle. This often involves extending your loan term, which lowers your monthly payments. Reputable, experienced counselors may be able to help get some of your interest rates (like penalty rates) lowered, get creditors to waive fees, and even put a stop to stressful collection calls.
Most trustworthy credit counseling agencies are set up as nonprofits. These companies charge very low (sometimes no) fees to help you rebuild your finances in a more positive way. Look for someone who has a solid reputation and a high success rate for helping people get out of debt.
The best credit counselors are trained and certified and will show you their accreditation. You can find reliable, verified information about any credit counseling agencies you’re considering working with from the National Foundation for Credit Counseling (NFCC) at www.nfcc.org or the Financial Counseling Association of America (FCAA) at www.fcaa.org.