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Your Financial Life After Bankruptcy: How Your Credit Can be Improved By Filing a Bankruptcy

Posted by Kevin Chern

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One of the most common misconceptions about filing for bankruptcy is that your credit rating will be severely damaged and you won’t be able to get any new credit for 7 – 10 years after filing. This is totally untrue. The overwhelming majority of people who file for bankruptcy can have a better credit score one year after filing than they had just before they filed their cases. There are a number of factors that contribute to this.

Why your Current Credit Score is Low Before you File for Bankruptcy

There are many different factors that go into determining what an individual’s credit score will be. Among those factors are the status of your open accounts, your debt to income ratio, percentage of credit used and the kinds of debt that you have.

Accounts in Default

Having open accounts in “default” or marked as “delinquent” will drag down your credit score more than any other single factor. When you miss payments or make payments late, your creditors can (and will) enter negative notations regarding the status of your accounts with the credit reporting agencies. When one or more of your creditors notates that your account is delinquent or in default, people reviewing your credit report and determining what kind of credit to extend to you will react negatively as well. This is because there is a general perception that people who have open accounts in default are either not creditworthy or they do not have the ability to pay the debts that they already have. In either case, it is highly beneficial for your credit rating to have a credit report free of delinquency notations from your creditors, especially for existing open accounts.

Debt to Income Ratio

Having a high debt to income ratio will drag down your credit score. Lenders are wary of offering more credit to people who may not have the ability to pay it off. Lenders see a person who has a great deal of debt with comparatively very little income as being a high risk. The lenders don’t want to take any more risks with their money than is necessary for them to turn a steady profit. Therefore, having a low debt to income ratio is important to getting the best credit score you can have.

“Maxed Out” Credit

When an individual has used all or nearly all of the credit available to him or her, credit lenders can be skeptical of offering new credit to that individual. This is due to a perception by lenders that people who use all or nearly all of their available credit have already been pushed to the limit of their ability to repay their debts by their current financial obligations.

Good Debt v. Bad Debt

You may have heard some people refer to “good debt” and “bad debt.” These are slang terms and there are no legal or technical definitions for them, but they are helpful ways to think of different categories of debt. The certain kinds of debt are seen as “good debt” because they can often lead the debtor to greater financial stability after having incurred this debt. This would include a first home mortgage or student loans. Other kinds of debt are seen as “bad debt” because the debt is driven by consumption and doesn’t lead to greater financial stability. This would include credit cards, personal loans and payday loans. There are also debts which fall somewhere in the middle, like medical debts. All debt will tend to hurt your credit score if not repaid in a timely manner, but “bad debt” is particularly harmful to your credit rating.

How Filing For Bankruptcy Can Help

All of these factors could be dragging your current credit rating down. Now, we’re going to talk about how bankruptcy provides a solution to these factors or refocuses your financial profile to highlight those things which have a positive impact on your credit rating.

Accounts in Default

The protections of the Automatic Stay, which we will discuss in greater detail in another post, prevent your creditors from making negative notations with credit reporting agencies immediately after they have been notified that you filed for bankruptcy. That means that all of those notations that are currently dragging your score lower, will no longer have that effect within a few months of having filed your case. Instead, your credit report will show a $0.00 balance, lose that input altogether, or read “discharged” once your case reaches the stage of being discharged by the Court. Without that dead weight, your score could improve immediately. Because of this, bankruptcy can help you improve your credit rating.

Debt to Income Ratio

Most bankruptcies discharge the majority of your debt. Chapter 7 of Title 11 of the United States Bankruptcy Code, in particular, discharges all “nonpriority unsecured debt.” This would be all credit card debt, medical debt, most utility debt, debt from services, personal loans and payday loans, to name a few. Once that debt is discharged, your debt to income ratio will be significantly better than it is today. If your debt goes down while your income stays the same or goes up, your debt to income ratio will be significantly improved over what it was before filing. In this way, bankruptcy can help to improve your credit rating.

“Maxed Out” Credit

There are a great many lenders throughout the country that are set up to do business specifically with people who have recently filed for bankruptcy. These firms do this because they know that the people who recently filed, either discharged much of their debt under chapter 7 or reorganized their old debt under chapter 13 and their credit is no longer “maxed out.” For many individuals in need of immediate credit (i.e. need a car for work), filing for bankruptcy could be their only way to get the credit that they need. In this way, filing for bankruptcy will help improve your available credit.

Good Debt v. Bad Debt

Generally speaking, all of the categories of bad debt that we discussed earlier (credit cards, personal loans and payday loans) are discharged by a chapter 7 bankruptcy unless there is some rare extenuating circumstance that would threaten that dischargeability. Even a chapter 13 bankruptcy can discharge most of it, depending on the client’s income. Additionally, a chapter 13 bankruptcy can often help reorganize those categories of good debt that we previously discussed (first home mortgage or student loans) so that the repayment of those debts are more manageable for the client. Once your bad debt is discharged and you are left with only good debt, you could see your credit rating dramatically improve. In this way, filing for bankruptcy could help you improve your credit rating.

Summary

To sum up, filing a bankruptcy under either chapter 7 or chapter 13 might help you raise your credit score within a year of filing. Of course, these are not the only factors that go into determining a credit score. To maximize your credit potential, you will need to continue to make good credit choices, but filing a bankruptcy and getting the fresh start you deserve can be a great place to start.

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Posted on June 15th, 2015


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