Ask a CFP® Professional
Keri Hughes, CPA, CFP®
Vice President and Senior Wealth Manager
PNC Wealth Management
Washington, DC

Question:

"My husband and I are planning to buy a home.  We would like to start paying off our debt in installments, but we don’t know where to begin.  I have several negative accounts and charge-offs on my credit report. Some are close to being erased over the next two years and others are fairly new. Recently, I have received offers to settle some of those accounts for fractions of what I actually owe.
 
My question is in three parts:

Q1:    How should I prioritize which accounts to pay off first?

Q2:    Do settled accounts have a different impact on my credit score than accounts paid off in full?

Q3:    If settled accounts do have a different impact on my score, what should I do to protect my credit score?

-DC Saver DW


Answer:

Q1:    How should I prioritize which accounts to pay off first?

A1:    All loans are not created equal.  In fact, I like to divide debt into three categories: The Good, the Bad, and the Ugly.  These guidelines are a great tool for determining who gets the biggest check each month.  More importantly, use them to avoid the “Bad” and the “Ugly” all together.  Your credit report will thank you!

The Good: (Yes, some debt can be.)  “Good” debts fund assets that will likely appreciate over time (i.e., a home, or an education); or assets that are critical in terms of affording you the opportunity to earn significantly higher income (a car or van necessary for a certain job).  Because these debts are usually attached to an asset called “collateral”, they tend to have the lowest interest rates.  So, let’s address these loans last.

The Bad: These are debts that typically where incurred to get you out of a jam, initially, like charging a new roof or a medical emergency. Sometimes a replacement auto must be purchased, when a balance still remains on the old one.  With no cash reserve on hand, the unexpected can become quite expensive.  Tapping into lines of credit, or charging big ticket items can bury you, especially when it involves paying for necessities.

The Ugly: These debts are “pure pleasure” – for the retailer or creditor that is.  The super giant flat screen TV that now hangs in the living room, or the Jimmy Choo’s that beaconed you from afar certainly seemed like a good idea at the time.  Now their cost has nearly doubled given all the interest you’ve paid, and there’s no where to run.

It’s easy to blur that line between needs and wants. So use cash for both going forward, and spare yourself the agony. Begin eliminating debt by paying off the highest interest rate debt first. Then begin to save for a rainy day. Remember, even “good” loan payments should NOT interfere with your ability to save on a regular basis.

Q2:    Do settled accounts have a different impact on my credit score than accounts paid off in full?

A2:    Unfortunately, the answers is, “it depends”.  Creditors are not under legal obligation to report your payment history (or lack there of) to a credit bureau.  So prevention is clearly much better than a cure when it comes to a bad credit score.

Reach out to the lender as soon as you anticipate an inability to pay, and try to negotiate a solution.  A “good faith” effort can go a long way in avoiding the late payment and charge-off reports. 

Once an account is paid off in full, ask the creditor to repair your status.  In some instances, payment is better late than never.  Often a creditor may be willing to report that you have made amends.  This is particularly true when there are circumstances beyond your control.  Plead your case, and be persistent.

Q3:    If settled accounts do have a different impact on my score, what should I do to protect my credit score?

A3:    You do have the right to tell your side of the story, at least 100-words worth.   A consumer statement can be included in your credit report, explaining the circumstances that led to the account problems reported within.  Provide this to each bureau, along with your account information.

Make sure all of your accounts that are in good standing are included on the report.  If something is missing, call the credit bureau, and request that they contact the account holders.  A nominal fee may be required, but it may save you hundreds in interest down the road.

Finally, keep an eye on your credit report to ensure there are no errors and/or out-of-date information.  Derogatory data must be removed within seven years.  So, as a last resort, you can always hunker down and wait out the storm.


-Keri Hughes, CPA, CFP®