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Shed debt baggage before pursuing new plastic

 
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August 20, 2013
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QDear Erica,

How can I get out of debt so I can get a credit card? – Rosemary

ADear Rosemary,

The best way to get out of debt is to pay it, and the best way to get a credit card is to apply for one.

Simple, right? In concept it is, but in reality, dealing with debt and getting a new credit account can be tricky.

Being in debt won't necessary bar you from getting a credit card. It all depends on how much debt you have and how you're treating it. If you defaulted on a debt (even a small one), that's worse than having several balances that you're dutifully paying down on time each month.Ask Erica

Because your letter was so succinct, I'll have to assume some facts about your situation: One, that you owe a lot of money to various creditors. Two, that you don't currently have an active credit card. And three, that big and possibly delinquent balances are driving your credit scores down (which is why issuers are telling you “no”).

This is what you need to do to achieve your goals.

Organize your debts
Gather your most recent statements, and make a list of those you owe. Include the interest rate, current balance and minimum payment. For example:

Organizing your debts
Creditor Balance Minimum payment Interest rate
Personal loan $1,500 $100 15%
Car loan $3,000 $350 7%
QVC $300 $25 21%
ABC Collection Services $500 N/A 10%
Bank of America credit card $2,500 $75 29%

Then review the status of each account, understanding what could happen if your creditors do not receive their full payment. For example, if you have a car loan, you may want to give that top priority because (depending on the state you live in) even one missed payment could result in a repossession. Or maybe one of your creditors is threatening legal action. You certainly don't want to be sued, because if you lose, the money you owe would increase dramatically and the creditor might be able to do all sorts of awful things, including claiming part of your paycheck.

Once you take a good look at everyone who is asking for their money back, reorganize the list so the debt with the worst consequences for non-payment is at the top, and the others follow. If any debts are equal in terms of ramifications, arrange them by interest rate, with the one charging the most in finance fees first. That list may now look like this:

Re-ordering your debts
Creditor Balance Minimum payment Interest rate
Car loan $3,000 $350 7%
Bank of America credit card $2,500 $75 29%
QVC card $300 $25 21%
Personal loan $1,500 $100 15%
ABC Collection Services $500 N/A 10%

Regarding accounts in collections, you'll see that there is no minimum payment. They want it all, right away. Collection agencies can be tough to work with, but some do accept installments. Whether they can charge interest depends on your state's laws. Be aware, though, that if the debt is old enough, it might be “time barred,” which means a creditor can't sue you for it. When exactly a debt becomes time barred varies by state. In any case, making a payment on it can start the clock over, so, after carefully reviewing your state's laws, you may want to leave it alone and then let it age off your credit report for good. That will happen seven years from the date it first went to collections.

Know how much you can send to your creditors
Subtract your basic monthly expenses from your monthly net income. Whatever remains should go to your debts. Pay the creditor at the top of your list the most, and the minimum to the others. After the first account is paid off, route that money to the one next on your list. Keep it up until all your balances are gone.

This activity will also show up on your credit reports. As your on-time payments are recorded and your balances deflate, your credit rating will steadily rise. By the time you're in the clear, your reports and scores will be significantly better than they are today.

Apply for credit when your credit is repaired
When you've satisfied your creditors, you can start to borrow money again. Get a feel for where you stand by checking your credit reports and scores. You can pull your credit reports free once a year at AnnualCreditReport.com. To view your FICO credit scores (the most widely used score), you can pay about $20 for each at MyFICO.com. Once you know where you stand, then apply for the best card for which you're likely to qualify.

Remember: All lenders want to see that you've been paying as agreed,  that you owe very little compared to how much you can charge and that you've got enough cash coming in on a regular basis to give them confidence that you can handle a new loan or credit line.

Can't wait until you're totally debt free or have excellent credit? Consider a secured credit card. Because you have to put a cash deposit down before you open the card, banks tend to be more lenient. Then, charge small, affordable purchases, always paying when you should.

And that's how you can climb out of the hole and put plastic back in your pocket.

Got a question for Erica? Send her an email.


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