People often don’t want to file for bankruptcy because they’re worried about the effect on their credit history. Should they be?
This is a surprisingly complicated issue. It’s true that bankruptcy, by itself, is considered a negative mark on a credit report.
But if you’re contemplating bankruptcy, there’s a good chance that your credit is already in pretty bad shape. In the long run, bankruptcy can give you an opportunity to rebuild your credit.
Credit Reporting: Just the Facts?
Credit reports by themselves present objective facts. They contain information such as how much debt you have, your record of making payments timely or late, and whether you’ve filed for bankruptcy.
To make sense of your credit report, lenders use software that takes the raw data from the report and generates a number, called a “credit score.” Most lenders get credit scores from Fair Isaac Corporation, also known as FICO. While the lender may consider other factors, the decision whether or not to extend credit can depend heavily upon your FICO Score.
Credit Scoring: Straight From the Horse’s Mouth
FICO’s credit scoring models are trade secrets, like the formula for Coca-Cola, so we don’t know exactly how your score is calculated. Still, FICO has revealed two things that help us understand the credit impact of a bankruptcy filing.
First, even though a bankruptcy filing stays on your credit report for 10 years (Chapter 7) or 7 years (Chapter 13), FICO tells us that “past credit problems impact your score less as time passes.” This is true for both the bankruptcy filing itself as well as your pre-bankruptcy credit trouble.
Second, 30% of a FICO Score — that is, almost 1/3 — depends upon how much debt you have. The more you owe, the lower your score. This part of your score should benefit from wiping out your debt with a bankruptcy filing. After you receive your discharge, you’ll want to get your credit reports and make sure that past debts are being correctly reported with zero balances.
Making the Most of the Bankruptcy Fresh Start
If you manage your credit well after bankruptcy, you should see improvement as time goes on. Still, it’s important to keep things in perspective and understand there’s more to financial health than your credit score.
The main benefit of having “good credit” is being able to borrow money, and that means taking on debt. If you’re considering bankruptcy, it’s because you want to get out of debt. Going back into debt defeats the purpose of filing for bankruptcy, doesn’t it?
Bankruptcy provides something very valuable: a clean financial slate. Where you go from there is up to you, but I always encourage my clients to make the most of their fresh start.