If you are considering bankruptcy, you may be wondering what effect a bankruptcy filing will have on your credit score. Will a bankruptcy filing ruin your credit forever? Is it possible to recover? How long will it take to rebuild my credit after bankruptcy?
What is credit anyway?
To understand how a bankruptcy will affect your credit, we first need to understand what “credit” actually is. When people refer to their credit score, they are referring to an assessment done by the credit bureaus of their credit risk. The credit bureaus (Experian, Transunion, and Equifax) compute data based on a combination of factors. Several of the factors include the total amount of debt you have, how many debt accounts you have open, the number of late payments on accounts, length of time accounts have been open, any judgments or liens filed, job stability, address stability, and we as other factors.
Your credit score is an overall grade of how risky it would likely be to lend you money. So a high credit score generally signifies that you are more likely to repay the loan, or in other words, less risky to lend money to.
What will bankruptcy do to my credit?
Most people that need bankruptcy relief already have a low credit score. They have already had their credit cards, medical bills, and other creditors report late payments. Frequently, their credit score has already taken a big hit and is in a downward spin. Bankruptcy can help these people to increase their credit score. The effects will happen both in the short term and long term. When you file bankruptcy, especially under Chapter 7, you are discharging or eliminating out most, if not all, of your debt.
This results in several things in the short term. First, when the bankruptcy is filed, the automatic stay of relief immediately stops creditors from continuing to report the accounts as delinquent. This will stop their credit score from continuing to drop every month, and will allow them to start rebuilding it. Second, the creditors will have report to the credit bureaus that the debtor no longer owes them anything upon entry of the bankruptcy discharge. Thus the credit report will now show these debts as having a zero balance. Having a lower outstanding debt tends to increase your credit score overall.
The long term effects are somewhat different. Individuals are allowed to file for chapter 7 bankruptcy once every 8 years. If a debtor needs to get a loan after their bankruptcy, they cannot eliminate that debt in another chapter 7 bankruptcy until 8 years have passed since the prior bankruptcy case. Because debtors cannot file bankruptcy again for 8 years, the likelihood that a creditor will be repaid are high, and therefore they may be more willing to lend money to a debtor that has a prior bankruptcy. Creditors still want to know that someone they are loaning money to has the ability to repay. Don’t expect to go apply for a car loan and get approved if you are unemployed.
Now what? How can I rebuild my credit after bankruptcy?
Okay, so you have filed your bankruptcy, followed the court process and received your discharge. But, now what do you do? The purpose of filing bankruptcy, which is even described in the Bankruptcy code itself, is to allow the Debtor a “fresh start” free from the burdens of their creditors. This fresh start is just the first step. While your bankruptcy discharge will eliminate any personal obligation to pay on your debt, the effects that led up to the bankruptcy filing may still be felt for years to come. Let’s discuss a few areas that will help you in the process to rebuild your credit.
Get in Control
The rebuilding process after bankruptcy is not a quick one, but it is possible. Keep your end goals in mind. Those goals for you may be purchasing a home in the next few years, or possibly a car. It is entirely possible to increase your credit score over a two year period after your bankruptcy is done, and be able to qualify for a home loan. I often recommend to clients to wait a several months after bankruptcy to get their post-bankruptcy habits established before they try to get any new loans or credit cards. Get your budget in control. Cut back on expenses that you don’t absolutely need. Make a plan and stick to it.
Take Baby Steps
A great baby step to take is to get a secured credit card with a small limit or around $200-300. This will require you to put down $200 up front for the creditor to use as a security against your purchases. But the credit card company will report your credit history to the credit bureaus. This is what will help improve your score. Use this card for a few small purchases, maybe $50-75 every month, and then pay the balance off. Ideally you should never have the balance over 50% of the maximum limit.
Stability
Another key to improving your credit score is demonstrating stability in your life. Being employed by the same employer for an extended period of time will help to demonstrate stable employment, and stable income. Living at the same address for an extended period of time demonstrates a stable living environment. Maintaining payments on your secured credit card for an extended period of time shows your ability to make monthly payments on time. All of these will help your score improve.
No More Late Payments
A critical area to rebuilding your score is to avoid late payments. Late payments of any kind can be reported on your credit, and will hurt your credit score in a very big way. The benefit of the “fresh start” can be undone if you fall back into pre-bankruptcy problems of late payments, collections, lawsuits, garnishments, and the like. Therefore, it is absolutely imperative that you remain current on any bill that is in your name such as utilities, car payment, cell phone, rent/mortgage, credit card, etc.
Save!
Save some money every month. Do whatever you can to structure your budget so every month you can put some money aside. It doesn’t matter how much, even $10-15 a month will help. The more you can save the better. Creditors do put weight on your debt-to-income ratios but also your debt-to-asset ratios when they are considering lending you money. Building a savings will increase your asset value. In addition, it will demonstrate your ability to manage your finances.