When struggling with debt, many debtors are apprehensive to file bankruptcy. This can be due to a perceived stigma, false perceptions, or a misunderstanding of how credit scoring works. Many credit-related companies, from credit card companies, personal loan lenders and even debt settlement companies try to re-enforce that stigma. The fact is that most people who are considering filing for bankruptcy already have poor to fair credit. Most are behind on their bills, have high balances compared to their credit limits, or are only making minimum payments. All of these factors affect credit scores. Bankruptcy offers debtors a fresh start, which allows people a chance to rebuild their credit and avoid these credit pitfalls, whereas maintaining the status quo and not filing is unlikely to result in improved credit. It also may unnecessarily cause a debtor to financially struggle in the interim.
While a bankruptcy filing can remain on a debtor’s credit report for up to 10 years, it does not mean that they cannot improve their credit score and obtain credit post-bankruptcy. Lenders review credit reports but use their own internal guidelines to determine who gets credit and when. In fact, many lenders specialize in post-bankruptcy lending. However, it can take time to rebuild credit after bankruptcy, it just takes some patience, persistence, and planning. Credit can also be rebuilt after bankruptcy quicker than one may think.
Best practices to rebuild credit after filing for bankruptcy
Most of our clients see an increase in their credit score shortly after receiving their bankruptcy discharge. Typically, a debtor who’s filing for bankruptcy may experience a 100-150 point credit score increase approximately one year after filing. To make sure a debtor receives the most benefit to their credit post-bankruptcy, we recommend that a debtor review their credit reports approximately three months after receiving a discharge and annually thereafter to confirm that it is accurate and up to date. Checking credit reports regularly can help a debtor find and dispute any errors. When reviewing a credit report, the following should be confirmed:
- The filing date of the bankruptcy is correct on the credit report.
- The accounts that were discharged in bankruptcy are noted on the credit report as “discharged.”
- The discharged accounts should be reporting a $0 balance.
Any errors should be disputed with the credit reporting agency and the incorrect information should be identified. Debtors should also avoid hiring a credit repair company. Any disputes can be done easily online.
Credit scores are based on a range of factors and there are a number of different credit score models that lenders and credit bureaus may use for their calculations. Most credit scoring models consider the following factors:
- Payment history, which is the most important factor in calculating a credit score, accounts for 35% of a credit score.
- Credit utilization ratio, which represents the amount of credit a debtor is using divided by the total credit available to them, accounts for about 30% of a credit score. Lenders typically like to see a credit utilization ratio of 30% or below but keeping it under 10% will improve a credit score.
- Length of credit history, which is determined by how long a debtor’s credit accounts have been open. The older the accounts are, the better the impact on one’s score. This can account for 15% of a credit score.
- Credit mix, which refers to the diverse types of credit a debtor has. Credit mix accounts for about 10% of a credit score.
- Hard inquiries, which help lenders track how often a borrower has requested a new credit account. Too many hard inquiries in a brief period of time can have a negative impact on one’s score. The new credit activity is responsible for about 10% a credit score.
Improving a credit score rarely happens overnight. Credit scores typically update once per month when lenders report to the credit bureaus and that data is then utilized by credit scoring companies. The length of time it will take to improve a credit score depends on one’s unique financial situation. At the earliest, a debtor may see a change in their credit score between 30 and 45 days after they have taken steps to positively impact their credit reports. However, high credit scores are a result of good financial habits that are maintained over a long period of time. There is no single, magical solution to quickly build a positive credit history. Post-bankruptcy, debtors should aim to establish and maintain good credit habits and have patience with the process. It may take a few years to recover credit-wise from a bankruptcy, which is why starting with an accurate credit report after bankruptcy is important.
Once a debtor determines that their credit reports are accurate, they should start to use credit wisely. While many online resources recommend secured credit cards, we have found that many of our clients are receiving pre-approved credit card offers shortly after they receive their bankruptcy discharge. We feel a debtor should accept such an offer but then should use that credit card wisely and pay it on time every month. These on-time payments will then also be reported back to the credit bureaus, which will help improve a credit score with its positive payment history. The initial credit limit may be as low as $350 but will increase as credit worthiness improves over time.
A secured loan, such as a car loan, is another effective way to build credit. Since the loan is backed by collateral (the vehicle which can be reclaimed by the lender if the loan is not paid), the lender may be more willing to approve such a loan. While financing a vehicle may be possible shortly after discharge, if a debtor waits at least a year, they will most likely obtain much better terms on the deal. Another type of secured debt that can be obtained in as little as 2 years after bankruptcy is a mortgage. Under FHA, USDA and VA programs, debtors with a discharged bankruptcy can obtain a mortgage to purchase a home as soon as 2 years after bankruptcy filing. However, if a conventional mortgage is desired, the waiting period is typically 4 years. Ironically, many debtors are often in a better situation to obtain a mortgage after bankruptcy since there are no large debt balances which could affect the debt-to-income ratio when looking to qualify for a loan.
Proactively managing credit after filing for bankruptcy could put you back above a 700-credit score (good-risk range) sooner than anticipated. This means wisely obtaining and managing credit, minimizing credit card utilization, paying off balances, and being punctual in repaying debts. It may not seem like it but rebuilding credit after filing for bankruptcy is not only possible but typical. To make sure your credit improves to the fullest extent possible, it is also important to annually review your credit report for accuracy. An accurate credit report leads to a financially healthy credit report. Personal bankruptcy can serve as a great financial opportunity. And as we often say, “bankruptcy is not the end, it’s a new beginning!”
Online Resources
https://www.annualcreditreport.com/index.action
