Often, I share advice about how to get out of debt and live debt free. But, what if you’ve already eliminated your debt through a bankruptcy or proposal and you’re ready to get back on track? What’s next? Today, I am going to share tips on how to rebuild your credit.
First, I don’t advise that anyone, after completing a consumer proposal or bankruptcy, jump right in and start borrowing again. If you can live without debt, that’s great! However, in today’s modern economy, you might need or want access to credit. And if you want to borrow and keep your interest costs low you need a good credit score. On today’s show we discuss tangible steps you can take to improve your credit score after a consumer proposal or bankruptcy.
Below are just the highlights. Listen to the podcast for more detailed information or download our free Credit Rebuilding 101 e-book.
Rebuilding credit starts with repairing your finances first. This is because if you don’t have debt under control, repairing your credit will be much harder. Here are the top 5 steps to rebuild credit wisely:
Your goal may be to buy a car or house, or it may simply be to have a credit card for emergency use. Perhaps your goal is to save money for retirement, and credit isn’t important. Either way, you need to define your goals so you can work towards them.
Write down all of your goals, and make them as specific as possible. Put dollar amounts with them, and time frames. ‘I want to buy a house’ is a goal, but it’s not very specific. Write down ‘I want to buy a house for $300,000, and I want to save up a $60,000 down payment, and I want to buy the house within five years.’ That’s a very specific, measurable goal.
The successful completion of a consumer proposal or bankruptcy eliminates credit card debt, tax debt, bank loans, payday loans even some student debt. That’s very important. You may have some secured debt, like a car loan, that was not eliminated. It’s up to you to decide if that debt should also be eliminated as you rebuild your credit.
Step #3 is an obvious one, but I see a lot of people slip up on this one. Step #3 in rebuilding your credit is avoid all unnecessary new debt. Getting a payday loan soon after your bankruptcy is finished is a recipe for disaster, so avoid it. While it may not impact your credit report, payday loans have a much more serious impact on your ability to rebuild your credit: high interest.
The fourth step in rebuilding your credit is to save money. You will have a greater chance of getting a car loan if you have a larger down payment, so savings are important. Even more important, savings are a great insurance policy against unexpected life events, and that’s important if you don’t have credit cards to use in an emergency. The greater the down payment, the less mortgage insurance you need, and that can save a lot of money in the long run.
Rebuilding credit begins with dealing with your debt first then taking these specific actions to repair your credit history.
Resources mentioned in the show:
Usually here on Debt Free in 30 we talk about how to get out of debt, and live debt free.
So what happens if you follow the advice that our guests give, and you eliminate your debt. Then what? We spend most of our time on this show talking about getting out of debt, but we don’t talk about what happens next. What if I’m out of debt, or almost out of debt? Then what? What if I had to do a consumer proposal or bankruptcy to eliminate my debt, and now I’m out of debt, and I want to get back on track?
That’s what we’re going to talk about today on Debt Free in 30: how to rebuild your credit after a consumer proposal or bankruptcy, or many other events that impacted your credit.
Let me start by saying that I don’t advise anyone, immediately after a consumer proposal or bankruptcy, to immediately go out and start borrowing again. If you got into trouble because you had access to too much credit, you don’t want to go back to having those same problems again.
However, in today’s modern economy, access to credit is very important to some people. If someday you want to buy a house, or finance a car, you need a good credit score, and today we are going to discuss tangible steps you can take to improve your credit score after a consumer proposal or bankruptcy.
Perhaps you don’t plan to buy a house. Perhaps you drive an older car, and when it needs to be replaced you’ll pay cash for an inexpensive vehicle. Maybe you live in the city and don’t need a car. That’s great. Perhaps you don’t plan to borrow any money in the future, but you may still need access to credit. Why? Because there are some things that you need a credit card to use that service. Even if you plan to pay cash, it’s difficult to book a hotel room if you don’t have a credit card.
Even something as simple as a service like Netflix often requires a credit card for the monthly payment. You may have cut your cable TV to save money, and that’s great, and Netflix or a similar service may be a lot cheaper than cable TV, but you may need a credit card to set up the service. Perhaps you gave up your car to save money, and now for that occasional long trip you rent a car, because it’s a lot cheaper than owning a car. That’s great, but to rent a car you need a credit card.
So how to you get a credit card, and start rebuilding credit, if you have bad credit? That’s what we will talk about today, starting now. I recommend a 5 step credit rebuilding plan:
Step #1 – Set Your Goals
You may be listening to this and saying “forget about my goals, I want to rebuild my credit, so let’s get on with it”. I get it, but I think it’s very important that you decide why you are trying to rebuild your credit before you actually get started, because your goals will determine your next steps.
If your goal is to get a credit card so you can book a hotel room, the steps to take are a lot simpler than the steps you need to take if you want to get a mortgage someday. That’s why goals are important. Your goal may be something simple, like getting a credit card with a small credit limit so you can book a hotel, rent a car, or purchase goods online. Your goal may be larger, like financing a car or buying a house.
Maybe your financial goals have nothing to do with credit. Perhaps you want to save money so that you can send your children to college. Perhaps you want to save for your own retirement. Savings goals are different than credit goals, so it’s important to set your goals so you know what steps you need to take next.
So here’s my advice:
Get a piece of paper, or open a document on your computer, and write down every possible goal you can think of. Big or small, write them all down. Simple goals, crazy goals, even goals that you may never be able to achieve, write them all down.
Goals I would consider would include credit goals like:
Savings goals could include:
Write down all of your goals, and make them as specific as possible. Put dollar amounts with them, and time frames. “I want to buy a house” is a goal, but it’s not very specific. Write down “I want to buy a house for $300,000, and I want to save up a $60,000 down payment, and I want to buy the house within five years”. That’s a very specific, measurable goal.
Now that you have all of your goals, rank them in order of importance to you. Which one do you want to accomplish first? Which is the most important? Once you are done, you will have a clearly defined set of goals, with amounts and time frames. For some of you this will be easy. Your only goal is to buy an inexpensive car, so you can start immediately.
Other goals may be more difficult, and may require some research. For example, you can save for a house, or for retirement, many different ways, including through a TFSA or and RRSP. Which is better? That depends on your age and some other factors, so some research may be required to fine tune your goals.
Once your goals are set, it’s time to move on to Step #2.
This may seem obvious, but step number two is to eliminate all unnecessary debt. If you are in a consumer proposal or a bankruptcy, this means completing all of your payments and other duties to complete the process as fast as possible.
Many credit rebuilding steps can’t happen until your proposal or bankruptcy is done, so the sooner you can finish making your payments and completing your other duties, the sooner you can take steps to actively rebuild your credit.
Information on your credit report remains for a pre-determined period of time, which is why finishing your bankruptcy or consumer proposal on time is important. When you file a bankruptcy or a consumer proposal, a note is placed on your credit report indicating the type of filing, and the date of filing. When you are discharged, another note will appear, indicating the date of discharge from your bankruptcy, or the date your proposal was completed.
For example, for a first bankruptcy, Equifax will display the information about your bankruptcy for six years from the date of discharge. For a consumer proposal, Equifax will display the details of your proposal for three years from the date of the completion of your proposal. That’s why you rebuild your credit score faster by paying off your consumer proposal faster.
If it takes five years to pay off your proposal, the note appears on your credit report for a total of 8 years; five years for the proposal, plus an additional three years until the note is automatically purged. If you pay the proposal off in 3 years, the note would remain for a total of six years.
Bottom line: the sooner you finish your proposal or bankruptcy, the sooner the note is removed from your credit report.
Step #3 is an obvious one, but I see a lot of people slip up on this one. Step #3 in rebuilding your credit is avoid all unnecessary new debt.
I see a lot of people who run into a cash crunch and they go and get a payday loan, or other short term loan, to stay afloat. That is almost always a bad idea. Many payday loan lenders don’t report to the credit bureaus, so you may think it’s no big deal getting a payday loan. While it may not impact your credit report, payday loans have a much more serious impact on your ability to rebuild your credit: high interest.
In Ontario a payday lender can charge $21 for every $100 you borrow, so if you borrow $500 today, you will be paying back over $600 on payday. If you didn’t have the $500 today, what are the chances that you will have $600 on payday that you can live without? Payday loans can easily start a vicious borrowing cycle, so I strongly recommend that you avoid payday loans. Since most of them don’t report to the credit bureau they won’t help you rebuild your credit, and their high cost reduces your savings, so they should be avoided.
Speaking of savings, let’s get on to Step #4
The fourth step in rebuilding your credit is to save money. Why? Two reasons: First, banks like to lend money to people who don’t need it. If you have money in the bank, the bank is more likely to want to consider you a better risk, so it’s easier to get a loan. Second, as you are rebuilding your credit, it’s likely that you will require a higher down payment or security deposit when you borrow.
If you want to finance a car, having a $3,000 down payment will make it easier to get a good interest rate on your new loan than if you only have a $500 deposit. The higher the down payment, the less risk to the lender, so the more likely they are to give you the loan.
If your goal is to buy a house, a down payment is critical. At a minimum you need a 5% down payment, but if you have less than perfect credit, and you want the best rate, a 20% or greater down payment is recommended. Currently in Canada mortgage insurance is required if you have less than a 20% down payment. Mortgage insurance increases the cost of your mortgage.
For example, if you only have a 5% down payment, meaning your mortgage is 95% of the value of the home, mortgage insurance through CMHC is a 3.6% premium on the value of the total loan. That’s a big number.
So if you buy a $300,000 house, with only 5% down, that’s a $15,000 down payment, you pay a CMHC mortgage insurance premium of 3.6% of the $285,000 mortgage, or $10,260. So when you buy the house you either have to pay $10,260 up front, or it gets added to your mortgage, so now your mortgage instead of being $285,000 is $295,260. That’s a big difference.
In most cases if you have a 20% down payment the bank won’t charge you a mortgage insurance premium, so by having a decent sized down payment you save a lot of money.
I said that Step #1 was to set your goals, and now you can see why. If you goal is to buy a house, you need to know what the house will cost, and how much of a down payment you will need, so that you have a savings goal in mind, which will save you a lot of money, and help you borrow at a much cheaper rate.
A lot of people ask me, what’s the best way to save? The answer is: make it easy. It has to be automatic, or else you may not do it. If your goal is to save $200 a month as the first step towards rebuilding your credit, and you get paid every week, I would have the bank set it up to automatically transfer $50 every payday to my savings account. The money would be automatically transferred, so I won’t see it, so I’m much less likely to spend it.
The next question I get asked is where to put the money: in a savings account, or a TFSA, or RRSP, or somewhere else? The answer again depends on your goals. If you are saving money to buy a house, either a TFSA or an RRSP may be a good option. The answer will depend on a number of factors, including your marginal tax rate today, and what you expect it to be in the future, how much contribution room you have, and when you need the money. The answer will be different for everyone.
An RRSP is a tax deferral method, meaning you get a tax deduction today when you put the money in your RRSP, but you pay tax on it when you take it out. So if you are off on maternity leave this year and not paying much in taxes, it may not make sense to contribute to your RRSP today and save a small amount of tax, only to withdraw it at some time in the future when your tax rate is higher. In that case a TFSA may be better.
With a Tax Free Savings Account you don’t get a tax break when you put the money in, but you can withdraw the money, including any interest or capital gains, tax free. So if your income is lower now but will be higher in the future, a TFSA may be a good option.
With an RRSP you can withdraw money and use it as a down payment on a home purchase, but then starting the year after you buy your home you have to repay it over no longer than 15 years, with a payment of at least 1/15 each year. If you don’t pay it back it gets automatically added to your income, and you pay the tax that year, so again if you are in a higher tax bracket that may be costly.
So again, my advice is to set your goals, and then make a plan to achieve those goals.
With that background, it’s time for Step #5, the important step, establishing credit, so we’re going to take a quick break and be right back with some practical advice on how to rebuild credit.
Segment #2 – Rebuilding Credit
Welcome back to this special Credit Rebuilding episode of Debt Free in 30. As we discussed in the first segment, if you want to rebuild your credit you need to set your goals, eliminate your debt, avoid any unnecessary new debt, and begin a savings plan so that you have cash to use as a security deposit or down payment on whatever you are borrowing for.
Step #5 is to take specific steps to rebuild your credit. More specifically, you want to improve your “credit score”. What’s a credit score?
Well with Equifax, your Equifax credit score is a number between 300 and 900. 300 is the worst, 900 is the best, so a higher number is better. Any number over 760 is excellent, and would generally allow you to get a loan at the best rates.
729 to 759 is very good
660 to 724 is good
560 to 659 is fair
And anything below 560 is poor.
So, your first goal is to get your credit score above 560, because if it’s below 560 you will have a very difficult time borrowing. Your next goal is to get over 660, so that you are in the good range. Ultimately you want to get over 760, which is excellent credit.
Let me emphasize a very important point here: Your credit score is for the bank’s benefit, not for your benefit. Credit scores are designed to help the bank decide if they should lend to you. They are there for the bank’s benefit, not your benefit.
So again, your credit score is only important if you want to borrow in the future. How important is it? Well, I can’t tell you for sure, but a recent study showed the following results:
In the survey, the person was trying to borrow $15,000 for a car loan for 48 months. If they had a great credit score of 760, they could borrow with zero down at a 4.8% interest rate, or about $344 per month. With a score of 590, which is only fair, they needed a 10% down payment or equivalent trade in, and the interest rate was 16.5%, which is $429 per month.
A credit score of 490, which is poor, resulted in a 20% down payment required, and an interest rate of 29%, for a monthly payment of $531.
So it’s possible to borrow with poor credit, but in this example the difference between an excellent credit score and a poor credit score was almost $9,000 in extra payments on a $15,000 car loan over 4 years. That’s huge, and that’s why you want a good credit score before you try to borrow.
The same math applies if you are buying a house. Most lenders will want you to have a credit score of 600 or more before they will give you a mortgage, and “A” lenders, like the banks, typically want 650 or more.
So what’s used to calculate your credit score? Equifax and TransUnion won’t tell us, because they don’t want people trying to game the system, but here are the factors that we believe go into your credit score.
So to improve your credit score, you need to work to improve each credit scoring factor.
Payment history is the biggest one, so you want to pay off all of your obligations on time. Most cellphone companies report to the credit bureau, so you want to make sure you are paying your cellphone bill, for example, on time. If you are late, it will negatively impact your credit score.
Amounts owed is the next most important factor, and utilization is important. Utilization is the percentage of allowable credit that you are using. If I have a credit card with a $10,000 limit, and I’m carrying a balance of $2,000, that’s a 20% utilization. Your goal should be to keep utilization below 30%, and ideally below 20%. In most cases, the lower the better. If you have a credit card, pay it off in full each month to keep your utilization low.
Length of credit history is important, but that doesn’t mean you should carry a balance forever. The longer you have had a trade line the better, like a credit card or a bank loan, but you also don’t want to have too much debt, so there’s a balancing act here.
Time also refers to other areas, like the length of time at your current address, and length of time at your current job. If you move frequently, that will lower your credit score, because you appear to be less stable. Same with constantly changing jobs; it may hurt your credit score.
If you plan to move around a lot, it may be wish to keep a permanent address, like at your parent’s house, to keep your credit score as high as possible.
New credit and the types of credit used are the least important factors, but they are still important. Qualifying for one small new credit card is new credit, and it may help you qualify for the next trade line.
So to improve your credit score, here’s what I recommend:
First, have cash in the bank. We’ve already discussed why that’s important, but it’s very important, so I mention it again.
The next step is to establish two “trade lines”. A trade line is a debt that appears on your credit report. It could be a credit card, or bank loan, or line of credit. A car loan or an RRSP loan would be a trade line, as long as the lender reports it to the credit bureau. That’s a key point, because some debts don’t appear on your credit report.
If you owe back taxes to Canada Revenue Agency, that’s a debt, but CRA doesn’t report to the credit bureau, so it’s not a “trade line”, and therefore doesn’t improve your credit score.
A possible next step would be to get a secured credit card. There are a few places that do this, and I’ll put links in the show notes over on hoyes.com to show you how to do it. With a secured credit card, you place funds on deposit with the credit card company, and they give you a credit card. A typical example would be to put down a cash deposit of $1,000, and you get a credit card with a $1,000 credit limit. It works just like a regular credit card, except that your credit limit is only as high as the amount of cash you have on deposit. Secured credit cards generally also charge a monthly fee, so even if you are paying the balance in full each month there is still a charge for using the card. If you don’t pay in full each month you pay a huge amount in interest, so my advice is always pay your credit card in full each month.
A secured credit card reports to the credit bureau just like a regular credit card. It will show that you have $1,000 in authorized credit, and as we discussed earlier your goal is to keep your utilization as low as possible, which is why you want to pay it off, in full, every month.
I know some people who use their card to buy gas, and then they go home and make a payment on their card, so that they are never in debt.
So getting a secured credit card is a good way to establish a trade line on your credit report. You need to have cash for the security deposit, which is why the savings plan is so important. Who will qualify? It depends on the lender. Some credit card lenders will only give you a secured credit card once you are discharged from bankruptcy. Most of them will allow you to get a secured credit card while you are in a consumer proposal, once the proposal is accepted by your creditors.
What if you don’t have a security deposit for a secured credit card? Or what if you want to establish a second trade line?
Another option is an unsecured credit card. Again, I’ll put notes to all of this in the show notes for this episode over at hoyes.com, but it works just like a regular credit card. There is one card I know of that has a $1,000 credit limit, and you can get it even if you are bankrupt or in a consumer proposal. This card is not available if you are a second time bankrupt or in a Division 1 proposal, so it’s not an option for everyone.
There is a monthly fee, and the interest rate is very high, so again you would only get this card if you need to rebuild your credit, and you are able to afford the monthly fee, which as I record this is around $7 per month.
Again, the point is to determine your goals, crunch the numbers, and know what you are getting in to before applying for credit to start rebuilding your credit.
I’ve got more tips, but first a quick break. You’re listening to Debt Free in 30.
Let’s Get Started Segment
It’s time for the Let’s Get Started segment here on Debt Free in 30. Today we’re talking about rebuilding your credit, so since this segment is all about practical advice, let me summarize all of my top 10 tips for rebuilding your credit:
The starting point is to decide on your goals.
Eliminate your excessive debt. Having excessive debt hurts your ability to improve your credit score, which is why a bankruptcy or consumer proposal may be a necessary first step in rebuilding your credit.
Start saving money, because you may need it for a future down payment on a house, or car, if that’s your goal.
Get a copy of your credit report, preferably from both Equifax and TransUnion. You can get them by mail, for free.
If you are in a bankruptcy or consumer proposal, I recommend that you get a copy of your credit report three or four months after your file starts. There’s no point getting a credit report too soon after you file, because it can take up to three months for your status to be update on your credit report.
If you are planning to apply for credit for a major purchase, like a car or house, it’s a good idea to get your credit report three months before you apply, so that you have time to correct any errors.
You can apply for one free credit report per year, per organization, so if you want to get your credit report for free every six months you could apply to say, Equifax first, and then six months later apply to TransUnion, and so on.
When you get your credit reports, review them and confirm that all information is correct. If there are errors, fill out the Dispute Resolution Form that comes with your credit report, and send it back to the credit bureau. Obviously when you review your credit report you will look for debts that are reported incorrectly, but there are two other areas you want to correct: your address, and your employment information.
Your credit score improves the longer you are at the same address, and the longer you are at your current job, because it shows stability. Your credit report is only updated when the credit bureau gets new information, so if you haven’t applied for credit for a while, your information may be out of date.
So if your credit report shows your old address from five years ago, you can send a letter to the credit bureau with your new address, and with the date you moved to your new address. That’s the key point; the date matters. Of course the credit bureau knows that people could say they moved to that new apartment ten years ago, so they will require proof. A letter from your landlord would work, or even on old hydro bill showing your address would be sufficient.
For your job, a letter from your employer showing your start date is good, but even an old T4 slip or paystub would also work in most cases.
Let me caution you: if you have old debts that you haven’t dealt with, you don’t want to tell the credit bureau where you live, or where you work, because that will make it that much easier for collection agents to track you down, and potentially sue you and garnishee your wages. This advice only makes sense if you have already dealt with your debts. Otherwise, do your bankruptcy or consumer proposal first, and then update the information on your credit report.
Keep all of your obligations current. Pay your cellphone bill on time every month, because late payments will hurt your credit score.
Establish two new trade lines. If your goal is to get a mortgage or a car loan in the future, having two trade lines will help your credit score. A secured credit card, or an unsecured credit card, are generally the easiest ways to do that. Full details are available on our website at hoyes.com.
An RRSP loan is also an option. They are easiest to get in January and February each year, but most banks and investment companies offer them throughout the year, and the interest rates are generally reasonable, because you are investing the money in your RRSP at that institution. You can use the tax refund you get from contributing to your RRSP to pay down the loan.
Before you get an RRSP loan, make sure you can pay it back, and confirm that the lender reports to the credit bureau. If it’s a bank you’ll be fine, but if it’s an investment company, like a mutual fund company, they may not report to the credit bureau.
Keep your utilization rates low. Pay your balances in full every month. If you don’t, and your utilization is more than 30% of your borrowing limit, that could actually hurt your credit score, not help it.
If you are applying for a car loan or a mortgage, do all of your “credit shopping” together. Every time you apply for credit it hits your credit report, and if you are turned down for credit it hurts your score. So if you apply for a car loan at three different places, you will only get a loan at, at most, one place, so the other two places will not be new loans. That’s not a problem if all of those enquiries happen within a short period of time, generally two weeks or less.
So, if you apply at three different places the same day, it won’t negatively impact your score. However, if you apply at one place, get turned down, and then two weeks later apply at another place, that may hurt your credit score. The same is true for mortgages. Look for the best deal, and only apply at one place if possible.
Don’t apply for more credit than you need. Having too much available credit can hurt your credit score, but the bigger worry is that it becomes too tempting to actually use it. Having a big credit limit may lead you back in to debt, and that’s not good.
Those are my top ten tips for rebuilding credit and recovering after a bankruptcy or consumer proposal. That was the Let’s Get Started Segment. I’ll be back to wrap up the show right after this quick break, right here on Debt Free in 30.
Source: J. Douglas Hoyes, CA, LIT [https://www.hoyes.com/]