Bankruptcy laws were enacted to provide you with relief from your creditors by giving you a fresh start. This fresh start usually comes with a high price, namely, a sizeable hit to your credit. But there are ways that bankruptcy can actually help your credit in the short and long term. This will depend on your FICO credit score, financial circumstances, and other factors.
Your FICO Score
Like most people, if you carry debt, you probably also have a FICO score. A FICO score is a rating system that predicts how likely you are to pay your debts as agreed upon. It is mostly used by lenders to predict whether you will be a reliable borrower by making the payments on time. High FICO scores mean that you are good at managing your finances. Low FICO scores usually mean that you have been delinquent with credit payments, have high unpaid debt balances, or experienced other problems repaying debt.
(Learn more about credit scores.)
How Bankruptcy Affects Credit Scores
When you file bankruptcy, your FICO score can be negatively impacted almost right away. In fact, many consider bankruptcy as the worst impact to your credit score, compared to foreclosure and other debt collection actions. For more information, read Which Is Worse for Your FICO Score: Bankruptcy, Foreclosure, Short-Sale, or Loan Modification?
For most people, bankruptcy means that your FICO score will drop, at least temporarily. If you have a good credit score, but must file bankruptcy anyway, you will probably suffer the most. That is because the higher your pre-bankruptcy FICO score, the bigger the drop in your score after you file bankruptcy. On the other hand, if you already have a low credit score, bankruptcy won't hurt your FICO score that badly. This could potentially make it easier for you to improve your FICO score post-bankruptcy. For more information, read Nolo's Blog FICO Provides Insight Into the Impact of Foreclosure, Bankruptcy, and Short-Sale on Your FICO Score.
How Bankruptcy Can Help You Anyway
If you find yourself in a position where you must file bankruptcy, then your FICO score is not as important as the reasons for having to file bankruptcy. Getting a new loan or credit card is not as pressing as, for instance, a pending wage garnishment or mortgage foreclosure. Nevertheless, after you have obtained bankruptcy relief, you may find that the bankruptcy may actually help your credit. This is so even though the bankruptcy will remain on your credit report for up to ten years.
Short-Term Positive Effects
In some cases, you might see immediate results on your credit after bankruptcy.
Getting rid of "delinquent" account reports. If your credit report contained late payments and high credit balances, this is where a bankruptcy discharge can serve the greatest good. A bankruptcy will essentially wipe those debts clean. This is because debts that are discharged in bankruptcy must no longer be reported as “delinquent.” Instead, they will typically be reported as discharged or included in your bankruptcy. In some instances, this could even boost an already low credit score.
Improving your debt-to-credit ratio. Bankruptcy may help improve your debt-to-credit ratio. This ratio is a comparison of your outstanding debt to your available credit balance. It can account for roughly 30% of your FICO score. The lower your debt compared to your available credit, the higher your potential FICO score. If you have credit accounts with high credit limits, they are normally closed or frozen when you file bankruptcy. However, if you reaffirm debts with low balances and good credit limits, or obtain new credit accounts after your discharge, this can potentially boost your FICO score. That is because you have little to no outstanding debt compared to available credit limits, which results in a favorable debt-to-credit ratio.
Long-Term Positive Effects
By wiping your debt history clean, bankruptcy gives you the opportunity to start over. You have a another chance to get your finances right. If you budget properly and are disciplined with your money, you can lay the foundation for building good credit history. By not being burdened with the outstanding debt that you discharged in the bankruptcy, you should have more disposable income to make credit payments on time. If you establish a good track record of paying your new, post-bankruptcy debts, you can increase your credit score over time. This can happen as early as six months to a year after bankruptcy.
For more articles on how bankruptcy affects your credit, see our topic page on Improving Credit After Bankruptcy & Foreclosure.