Many people think of bankruptcy as financial Armageddon, the final act in a downward spiral that ends with a judicial order that discharges debt. As bad as bankruptcy is, it doesn’t leave a lifelong black mark on your finances, but restoring your financial good name takes effort as well as time.
Bankruptcy is a tradeoff. It wipes away or reduces debt that you can’t afford to pay, but it tells the world that you’re a credit risk. That gets reflected on to your credit score, which can drop dramatically and make it tough to borrow and spend. Getting a credit card, a personal bank loan or a mortgage can be very difficult in the near term, and it can take years before fallout from the bankruptcy to clear.
Before you file bankruptcy, you should understand the consequences. The negative impact on your credit score will last as long as seven to 10 years depending on the type of bankruptcy you enter. Until the nation’s three large credit-rating bureaus remove the bankruptcy from your credit report, you will live with the financial stigma. But you can take immediate step to begin restoring your creditworthiness.
A nonprofit credit counsellor can help you plan a strategy if you feel uncertain about what to do. If you follow a strict budget, pay your bills on time and use a secured credit card, the credit rating agencies could elevate your credit score to a solid level within four or five years.
Credit bureaus assign creditworthiness using a numeric scale. The numbers, called FICO scores, range from 300 to 850. The higher your score, the easier it is to get credit and the better the terms will be.
Credit card issuers and lenders regularly report your financial behavior to the bureaus, which in turn use formulas to arrive at your score.
An assortment of negatives can lower your score, including tardiness in paying bills, using too much of your available credit line, loan defaults, loans that enter collection and, worst of all, bankruptcy. A bankruptcy will lower the score tremendously, and the better your score was before you file, the more it will drop when the bankruptcy order is entered.
How much your score falls, and how quickly it recovers, has a lot to do with how you manage your money and your credit. Though the bankruptcy remains a negative on your credit report until it’s removed, you can begin seeing improvement if you make the right moves.
Assessing the Damage
FICO scores rely on a menu of criteria – the more negatives, the lower your score. Tracking your FICO score has become increasingly easy in recent years as many banks and credit card issuers now regularly post updated scores on their secured websites. For those who prefer getting information directly from the three large credit-rating bureaus, albeit not as quickly, free reports can be requested annually.
If you know your score and file for bankruptcy, get ready to watch it plunge. A person with an average 680 score would lose between 130 and 150 points in bankruptcy. Someone with an above-average 780 score would lose between 200 and 240 points. In the end, both people would be tagged risky borrowers, making it difficult or impossible to get loans or unsecured credit.
Individuals usually file bankruptcy under either of two chapters of the federal bankruptcy code. Chapter 13 stops collection actions and creates a plan for borrowers to partially repay creditors over a fixed number of years. Chapter 7 doesn’t have a repayment plan and eliminates most unsecured debts, meaning the creditors can’t recoup what they advanced.
Since Chapter 7 is more injurious to creditors, the damage it does to a credit report is greater. If you file Chapter 7, your bankruptcy will negatively affect your FICO score for 10 years. A Chapter 13 filing, because it involves partial repayment, remains on your record for seven years.
In both Chapter 7 and Chapter 13 bankruptcies, accounts that were delinquent before the bankruptcy was settled will remain on your credit report. In Chapter 7 cases, they will stay on the report for seven years and will be noted as accounts included in bankruptcy. Chapter 13 accounts are often paid off according to the bankruptcy agreement in three to five years. Since the debts are partially repaid, the account records will be removed from your credit report before sooner than Chapter 7 debts, which are never repaid.
Bankruptcy’s impact on your credit score will also vary according to how much debt you had discharged and the ratio of positive to negative accounts on your credit report. If your debt was fairly low and you had only a few accounts included in bankruptcy, your score probably won’t fall as much as if your overall debt was high and you defaulted on a large number of accounts.
Though you can’t do anything about the amount of time bankruptcy remains on your credit report, you can take steps that will speed the rate at which your score recovers.
First, don’t fall for a pitch from a credit repair company that offers to restore your credit rating for a fee. It can’t be done and anybody who says it can is a scam artist. The only way to begin rebuilding credit is to become a paragon of financial responsibility.
Here are some steps to help you rebuild:
- When you receive a legitimate bill for anything, pay it before the due date. If you have an account from before a bankruptcy filing (a home mortgage, for instance), make sure you never fall behind on a payment. If you filed Chapter 13, always make court-ordered payments to creditors on time.
- Open a secured credit card account. Credit card issuers will give you a secured card if you deposit cash that covers the credit limit. If you want a credit card with a $1,000 spending limit, you’ll post $1,000 to the card issuers as a security deposit. Though this might seem strange at first, it offers the convenience of paying with plastic and, if you make payments when they’re due, your credit score will improve.
- Monitor your credit score monthly using CreditKarma or Chase Credit Journey, two websites that provide scores. If you use credit responsibly and pay bills on time, your score gradually will rise. Eventually, you will be able to obtain an unsecured credit card, which you should do.
- Don’t go overboard. One secured credit card is all you need early in post-bankruptcy. Simply using the secured card and then paying the monthly statement in full will begin rebuilding your credit. If you had trouble managing money in the past, the disciplined use of a single card will not just rebuild your credit score, it might even help you build new and better spending habits.
- When your credit score begins improving, plan a spending strategy. If you qualify for a no-fee credit card, choose it rather than one that charges an annual fee. Make a budget and stick to it so you never again accrue debts that you’re unable to pay down monthly. If an emergency forces you to run over budget and run balances on your credit cards, aggressively pay off the card debt as soon as the emergency passes. Try to build an emergency fund so you don’t need to run credit card balances in the first place.
- If you have student loans, keep paying them. Student loans can’t be discharged through bankruptcy but paying them on time signals the credit-rating bureaus that you are managing your debt well, and that will help revitalize your credit score.
- Consider a credit-builder loan if you need money and have the means to repay the loans. Community banks and credit unions most commonly offer these loans at affordable interest rates. If you borrow $500 or $1,000 and pay it off on schedule, it will become part of your credit report and will help improve your score.
Make Big-Ticket Purchases
You might want to buy a house or a car soon after emerging from bankruptcy and then discover that no one wants to loan you the money. Even if you can find a loan, it likely will be at very high interest. You shouldn’t take a loan that would be difficult to repay. If you’re buying an auto, avoid shady dealers who operate buy-here, pay-here car lots.
Consider asking a relative or good friend to co-sign a loan, which will help lower the interest rate on your loan. Obviously, this is a risk for the co-signer, so finding someone who willing to help might be difficult. If you find a co-signer for either a loan or a credit card, make sure the loan or card issuer reports payments to the credit-rating bureaus. If you pay on time, your credit rating will benefit.
It might take years before you can qualify for a big loan at market interest rates, but the fastest way to get there is through financial recovery plan.