“How much will bankruptcy hurt my credit?”
This is one of the first questions people ask in a bankruptcy consultation.
But, far from being the “credit killer” people perceive it to be, bankruptcy can actually be a powerful tool for quickly rebuilding your credit.
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HOW UNSECURED DEBT AND HIGH UTILIZATION TANKS YOUR FICO CREDIT SCORE
The average potential bankruptcy filer has a lot of unsecured (usually credit card) debt.
Many potential bankruptcy filers have done a good job making minimum payments for years and years. But, they start to see that the huge minimum payments are preventing them from saving for the things they really want in life– a house, college funds for their children, and retirement savings.
Once they accumulated a certain amount of unsecured debt, they also saw their FICO credit score take a nosedive– even though they had never missed a payment.
This is because up to 40% of your FICO score is determined by (1) how much unsecured debt you have and (2) the percentage of your available credit you are using at any given time (called your “utilization rate.”)
More unsecured debt and higher utilization rates will give you a lower FICO score.
WHY YOUR FICO SCORE IS ALREADY LOWERED
While making timely payments is good for a person’s credit score, the FICO scoring model isn’t crazy about people making only the minimum payment required.
FICO also hates to see credit card utilization above 50% of the total credit line (and it prefers that you keep utilization below 30%.)
So, even when you make your monthly payments, FICO is probably already penalizing you with a lower score if you carry high balances and pay only the minimum payment due each month.
BANKRUPTCY AS A TOOL FOR REBUILDING CREDIT
Did you know it would take you 194 months to pay off a $20,000.00 credit card balance at 18.9% interest while making “minimum” payments of a whopping $800.00 / month?
I know very few people who can afford a “minimum” monthly payment of $800.00 / month. And, keep in mind the average American household has several credit cards.
Luckily, there is another way.
YOUR FICO SCORE DURING BANKRUPTCY
In our office, the average person filing bankruptcy sees a FICO credit score drop of 30-70 points in the month he or she files Chapter 7 bankruptcy.
Upon receiving a discharge 3-4 months after filing (for an average Chapter 7 case), the bankruptcy filer’s FICO score goes back up 20-80 points, on average.
The score goes up a bit upon discharge because the bankruptcy filer has become that rare creature known as a “debt free person.” While the FICO scoring model is not overjoyed about how you got there (via bankruptcy), the model does give you some points for wiping out the debts.
The real improvement in credit score comes around the one year anniversary of your bankruptcy filing date.
Around the one year anniversary of the bankruptcy filing date, the average bankruptcy filer sees a FICO score increase of 100 – 200 points (vs. their FICO score just prior to filing bankruptcy.)
And you can do it in about a year.
Sure, there is a temporary “dip” in the credit score during the 3-4 months you are completing your bankruptcy before receiving your discharge. But, that is a small price to pay for wiping out your debts and seeing the large FICO gains about one years’ time.
HOW LONG WILL BANKRUPTCY STAY ON MY CREDIT REPORT?
That’s actually in some ways the wrong question to ask. Most people need to know how long the bankruptcy will AFFECT THEIR FICO SCORE.
It is true that a Chapter 7 bankruptcy can be reported on your credit for up to 10 years after your bankruptcy filing date. A Chapter 13 filing can be reported for up to seven years after your filing date.
This could be an issue if a potential creditor has a firm policy against lending to anyone with a bankruptcy in their credit history.
But, many large institutional lenders might never even see your actual credit report– many only review your FICO credit score when deciding whether to do business with you.
These lenders might be more open to lending to a person with a recent bankruptcy.
THE TRADE-OFF (AND IN LIFE, THERE’S ALWAYS A TRADE-OFF…)
A Chapter 7 bankruptcy can make you a debt-free person very quickly. The tradeoff is:
- You may have to wait up to a year from your bankruptcy filing date to see a dramatic increase in your FICO score and
- The bankruptcy event itself can remain on your credit for up to ten years, which can be an issue for lenders who review your actual credit report and not just your FICO credit score.
The upside is, of course, becoming a debt free person in 4 months instead of after 20 years of huge monthly “minimum” payments.
A pretty huge upside, if you think about it.
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***Now for the disclaimers: a person’s FICO score is determined by his or her entire credit history and is thereofore highly individualized. So, it’s difficult to predict exactly what numerical effect any one event will have on a person’s FICO score. The point ranges discussed above are averages based on our clients’ (average bankruptcy filers) experiences over the years.***