I answer this question every day so it's time for a thread I can link to in my "homework" signature links.
FICO Scores don't look at all debts equally
Most folks who are rebuilding are looking to snag a higher FICO score for one and only one reason: so they can qualify and get approved for either more credit, or better credit options. That's the #1 reason for rebuilding, and sometimes it has to do with a mortgage desired, other times people want more cash back, and some folks "need" credit to float a large purchase like furniture or a big TV or an engagement ring.
FICO scores don't look at all debts equally. From chargeoffs to collections to public records like judgments or liens or foreclosures, bankruptcies and repos, each of these debts is looked at differently in FICO. I'll be talking about FICO Score 8, the most popular "flavor" of FICO for credit card approvals, but all flavors of FICO look at debts differently. Remember there are many flavors of FICO, including FICO Auto Score, the popular mortgage scores, and many others.
To conquer debt, one must first conquer savings
My rules on paying down debt have helped a lot of folks out over the years, except for myself! I didn't follow my own message which is why I found myself in the FICO gutter from 2015-2017. My own FICO score caved in 2015 because of a card I cosigned for and then ignored. It went to chargeoff status within 7 months of me cosigning for it, but I didn't know for over a year after because I wasn't using credit since 2005 or so.
Before you can pay down debt safely, you really need to get on your emergency fund. I've discussed and guided and documented a lot of folks' credit rebuild and financial paths to wealth and all of the successes and failures in the process came down to one thing: can this person live without income during their rebuild and after?
If your emergency savings account is $0 right now, you are not rebuilding credit. Instead, you're just piling on more debt, and this is going to bite you once again. Rebuilding credit doesn't mean just boosting your FICO scores, getting a mortgage approval or financing that fancy car. Rebuilding credit doesn't mean paying off your student loans or getting your bankruptcy to fall off your reports. Rebuilding credit means learning what messed you up in the past, and never allowing that to happen again.
Everyone here who is rebuilding credit is in that position for one reason: you didn't have enough money for a short period of time to just pay your minimums. It wasn't the debt total that crushed you, it was the minimum payments that crushed you. Think about that for a moment and learn from it.
STEP 1: Emergency savings teaches you better credit
When you get your emergency savings account equal to just 1 month's income, you start seeing credit in a new light. You can lose your job tomorrow and be OK for 1 month. Doesn't sound all that great, does it? That's because if your emergency savings is LESS than 1 month, you won't even make it to the next month without creditors calling and harassing you.
So the first step in 'what to pay down first' is simple: if your emergency savings account is LESS than 1 month of income, pay that first. You aren't going to do any good paying off a chargeoff or high utilization or collection if you aren't protected from what may happen in the future. There's no debate that I've heard in many years that has overcome this. I don't care if your interest rates are 42% on $50,000 in student loans, if you don't have at least one month's emergency income, you're not doing anything but finding new ways to overextend yourself.
STEP 2A: Paying down debts that make sense to pay down
Some debts don't make sense to pay down because they lose your negotiation power or have zero effect on your FICO score. Collections reported on your credit reports don't matter if they're paid or not (this varies in FICO 9 but we're focusing on FICO 8 which is much more popular with lenders). So you can pay all your collection accounts to $0 and your score will go up 0 points.
The first step (after your 1 month emergency income fund) is to see what accounts are reported "over limits". There are 3 ways this can happen:
- You have a chargeoff reported by the original credit (OC) showing any balance due
- You have open credit cards that report a balance higher than the limit
- You have loans that report a balance higher than the starting balance (for example, deferred student loans)
We can't do much for the 3rd group, so let's attack the first two. Chargeoffs may or may not accrue interest, but those balances are eviscerating your FICO scores. Open cards with overlimit balances are also cratering your FICO score, plus you may get new fees posted for being overlimit, plus you may anger your creditors who will be quick to lower your limits as soon as you pay them down.
My rule on paying down debt is never use more than 50% of your emergency savings to pay down chargeoffs, collections or overlimit cards, but attack overlimit cards first. If 50% of your emergency fund doesn't cover the amount you're overlimit, you need to work more, spend less or save more. Write this down if this is the case and post it on your computer monitor.
Remember that you may be overlimit on a card and pay down the difference and next month new interest posts taking you overlimit again and hitting you with new fees. So if you want to pay down an overlimit open account, pay it down to under limit plus also pay down whatever the interest posting will be. You can do the math to figure this out or ask for help in this thread.
STEP 2B: Overlimit open cards first, chargeoffs next
Now that your cards are no longer overlimit, your next step is to work on chargeoffs with balances. You are going to force yourself to never let your cards report overlimit again, so please make sure your future payments there are the minimum PLUS whatever interest might accrue. Also make sure to get your emergency income fund back to 1 month before continuing.
Once your emergency income fund is back to 1 month minimum, attack chargeoffs with balances. It doesn't matter WHICH accounts you pay, but pay them. I'd suggest paying each account equally to try to get the OC from selling or assigning the debt to a collection agency. Call the OC, tell them how much you have to pay THIS MONTH, and pay it. Don't make a payment arrangement yet until you've built your emergency savings account up past 1 month. If for some reason your emergency account is up to 3 months income, you are welcome to negotiate a payment arrangement with the original creditor.
Note: you are not using more than 50% of your emergency fund to pay down chargeoffs, and if you fall back to 50% of 1 month's income, you have to halt and get back to paying the minimums on open accounts while socking the rest into your savings account.
STEP 2C: Open card utilization
At this stage, you've paid all your credit cards so they're not overlimit. You've paid down all your chargeoff balances to $0. You've built up your emergency fund back to 1 month income.
The next step is to attack individual card utilization. This is not the "aggregate utilization" that MyFico or CCT reports. Snag a calculator out and type in any open credit card limit and hit the multiply button and type "0.689". So if your limit is $1000, type in "1000 x 0.689" and hit enter.
This is the number that each and every credit card (with different limits) needs to be under. 68.9% utilization. Go through each and every credit card you have and figure out which ones you can get below 68.9% right away. Remember that if you get charged interest and only pay down to 68.9%, on statement cut you will be OVER 68.9% again. So make sure to pay enough to get below 68.9% including whatever interest posts. Super important!
Once you've paid all your credit cards down to under 68.9% and your chargeoffs all report a balance of $0, you can expect a FICO score boost.
Your goal from this point forward is to never let a credit card ever report over 68.9%. You can use the card more, but make sure it reports less than 68.9%. If you ever go over that number, you're on my bad list. I will roll my eyes at you -- because you have an emergency savings account that means you never will let yourself get here again, ever.
STEP 3A: Collections and collection agencies
As mentioned, paying a $500 collection to $0 has no effect on FICO 8. Paying a $50,000 collection to $0 has no effect. So we need a different process.
My rule here is that you are now in a situation where you will be able to work your emergency savings account up to 3 months income. There's no different move because once it is up to 3 months income, I will allow you to use half of that (1.5 months income) to negotiate with collection agencies.
In writing, by mail, you will offer them a payment without accepting responsibility of the debt, only if they write back to you with a promise to delete this account from all credit reports. Don't accept them saying "we will report it as paid" or "we will report it as settled in full" -- this has no effect on FICO scores.
Some collection agencies will report back that they can't delete accounts. This is a lie. Just turn around and send a letter saying you will pay this account if they send you a letter confirming they will delete the account ("tradeline").
While you are writing these payment settlements to the collection agencies, you will continue to build your emergency savings account, keeping it at 3 months of income and no less, ever. If you pay off one collection agency in exchange for deletion, you can use up to 50% of your emergency savings account but you will not offer any other pay-offs until you are back to at least 2 months emergency savings.
STEP 3B: Beans and Rice Diet
It's not low carb, sorry. But if you're having issue raising your emergency savings account, it's time for beans and rice for every meal. Yes, your teenagers need more protein, but the rest of you can do it. There is no excuse for wanting new credit cards and a new home and a fancy car if you don't have 3 months of income saved. All that will happen is another life emergency happens in the future and you'll be back here asking for help once again. From volunteers.
The process all relies on you becoming responsible with finances
Emergency savings = responsible employee, responsible taxpayer, responsible debtor, responsible parent.
If you can't save 10% of your income every month, show me your spending and budget and I will tell you what to do. Chances are it means a second job, but that's life. If you don't like this idea, you're not mentally ready to actually reprogram your brain to becoming a responsible borrower who sleeps well at night without anxiety and stress over tomorrow's finances.
No new clothes, no restaurant dining or fast food, no Starbucks or Dunkin Donuts, no fancy groceries or movies or video games.
You CAN do this, and I know you can, because I've seen hundreds of others say they can't do it but a year later they are out of the bad credit situation and have 3-6 months of emergency income set aside -- some of them had to cut their spending to $0, others had to get a second job or drive for Uber. But almost everyone CAN do it, and you are probably in that group.
Starting Score: 500