Understanding Credit and the Effects of Filing for Bankruptcy
Most people who are considering filing for bankruptcy protection are understandably concerned about their credit score and the effect that bankruptcy will have on it. An individual’s credit score is important, as it is the single largest factor that will determine whether that person can finance a vehicle or obtain a mortgage. Understanding how a credit score is determined and the effect that bankruptcy has on your score will help you make an educated decision as to your best course of action.
Your credit score is designed to be a representation of your creditworthiness, the likelihood that if you borrow money, you will be able to pay it back under the terms of the loan. Your score is based primarily on your credit history. There are two generally accepted credit score models used. FICO is the most used model, with the newer VantageScore becoming more accepted within the lending industry. Both use a numerical score that ranges from 350 – 800, depending on the details of your credit history, and use the substantially the same factors to calculate your score. The higher the score, the better your creditworthiness.
There are five factors that are used to calculate your credit score, weighted differently, so some factors are more important than others in the calculation.
- Your payment history is the most important factor and counts toward 35% of your overall credit score. Timely payments on your debts raise your score, while late payments, defaults and collection actions lower it. This is also where the filing for bankruptcy protection has its largest impact on your credit score, as it draws a line in your history saying that rather than paying your debt back timely, you elected to seek a bankruptcy discharge.
- Your credit utilization is the next most significant factor, counting 30% toward your overall credit score. Credit utilization is a simple calculation that takes the amount that you owe and divides it by your total available credit, multiplied by 100 to create a percentage. The goal should always keep this as low as possible, with below 30% being optimal. A simple example would be if your total debt owed is $10,000 and your total available credit is $20,000, your credit utilization would be 50%, which is not good. On the other hand, if your total available credit is $100,000, then your credit utilization would be 10%, which is excellent.
- Next is the length of your credit history, counting 15% toward your overall credit score. This looks at your oldest open lines of credit, how old your newest lines of credit are and an average age of all of your lines of credit. The older the lines of credit you have are, the better it is for your credit score.
- After this the models look at your credit mix, counting 10% toward your overall credit score. This looks at the types of credit you have, between car loans, mortgage loans, credit cards, student loans and other lines of credit. The theory is that a mix of types of credit is healthier than having all of one type generally.
- Finally, the models look at your new credit applications and inquiries, which counts as the final 10% of your overall credit score. Each time that you apply for a new line of credit, it is considered a “hard inquiry or hard pull” on your credit. Having too many hard inquiries over a short period of time will damage your credit. It is worth noting that when you pull your credit report to check your credit, it is considered a “soft inquiry or soft pull” and does not have a negative impact on your credit score.
Typically, when an individual is considering filing for bankruptcy protection, their credit score has been on the decline for a period of time. Their credit history has a variety of negative reporting items, including late payments, defaults and collection activities taken against them, which are the primary reasons that they consult a bankruptcy attorney. Their credit utilization is generally too high as they have maxed out their existing lines of credit, their credit mix has skewed too far toward unsecured debts such as credit cards and personal loans and their new credit inquiries are high, as new lines of credit are sought to try and stave off collections and bankruptcy. This is not absolute, as people certainly recognize the need for a bankruptcy filing before their credit score plummets, but they are the exceptions.
Filing for bankruptcy protection will affect each of the five factors of credit score calculation, but not equally.
- Payment history – this is where bankruptcy has its biggest impact. The bankruptcy discharge, once issued, shows unequivocably that you were not able to pay back the debt that you incurred and this is reflected on every line of your credit report where a debt was discharged. Negative marks on your credit report prior to the bankruptcy remain on your credit as well. A Chapter 7 bankruptcy will remain on your credit report for 10 years, while a Chapter 13 bankruptcy will remain for 7 years.
- Credit utilization – this is a mixed impact for bankruptcy. While the amount of debt you owe is drastically reduced, most of your lines of credit are also closed, so both sides of the calculation are reduced. Individuals who keep financed homes and cars through a bankruptcy and continue paying for them have a lesser impact, even sometimes creating a positive impact, on credit utilization. Most, however, do not have that significant of a change in the credit utilization factor.
- Length of credit history – bankruptcy has a moderately negative impact on this factor. At the time of filing for bankruptcy, existing accounts that are discharged stop aging, eventually falling off your credit report. Any lines of credit opened after your bankruptcy are reflected, but they are “younger” than the pre-bankruptcy debts and need to age in order to improve your credit score.
- Credit mix – bankruptcy will have an immediate negative impact on this factor, whether you carry secured debts through the bankruptcy or not. With most or all of your unsecured debts discharged, you will lose your diversity of credit types.
- New credit applications & inquiries – bankruptcy will have a mild negative impact initially, as there will be few or no new inquiries that are approved and may be some denials.
As you can see, bankruptcy will have an immediate significant negative impact on your credit score. That, however, is just the immediate effect. With every negative impact that a bankruptcy creates, the fresh start provided by the bankruptcy gives you the opportunity to rebuild your credit responsibly.
- Payment history – bankruptcy provides a huge opportunity to rebuild your payment history. To do so, it is imperative that you maintain timely payments on every debt that survives the bankruptcy. If a debt survives that is not on a payment plan, you must get it onto a payment plan immediately and then maintain timely payments. As you open new lines of credit, you must always make timely payments. Over time, this, the most significant factor in calculating your credit score, will reover.
- Credit utilization – this is one of the easier factors to recover after a bankruptcy, as it is completely within your control. You will be able to incur credit after your bankruptcy discharge, but it is up to you to do so wisely, opening limited lines of credit and then keeping your utilization rate at zero (paying all balances in full when due).
- Length of credit history – there is not a lot to be done on this factor, as it is simply time that heals. As above, you will be advised to open a limited number of new lines of credit after the bankruptcy discharge. Once opened, you just need to let them age.
- Credit mix – similar to credit utilization, this factor is easier to recover because it is completely within your control. Limit the number of pure unsecured lines of credit that you open, such as credit cards. Once it is reasonable, open a secured line of credit or two. Then monitor your credit mix closely.
- New credit applications and inquiries – again, this factor is totally within your control. Limit the number of inquiries you have on your credit and ensure that when you do apply for credit, you have a reasonable expectation of being approved.
Now you understand how a credit score is calculated, the impact that a bankruptcy filing has on your credit score and where the opportunities are to rebuild your credit after your bankruptcy filing. While everyone’s financial situation is different, the general rule is that it will take 2-4 years after your discharge for your credit score to recover. Read Life After Bankruptcy for a detailed explanation of the steps to take to ensure that your credit score recovers as quickly as possible.
Bankruptcy was built on the core concept that the honest but unfortunate debtor should receive a fresh start. The credit industry recognizes this as well and you will have the opportunity to rebuild your credit score after your discharge. Proper planning and execution of that plan will allow you do so within a very reasonable time frame.
