How Bankruptcy Can Help Your Credit Score

A "credit score" is a number that supposedly summarizes your credit history and predicts the likelihood that you'll default on a debt. Lenders use credit scores to decide whether to grant a loan and at what interest rate.

FICO scores, the most common type of credit scores, range from 300 to 850. A FICO score is based on the information in your credit report, including:

• your debt payment history
• how much debt you currently have (including your debt-to-credit ratio)
• your different types of credit
• how long you've had credit, and
• whether you have new credit.

A high FICO score generally means that you're good at managing your finances, while a low FICO score usually means that you have been delinquent with credit payments, have high unpaid debt balances, gone through a foreclosure, filed for bankruptcy, or experienced other problems repaying debt.

If you're struggling financially, bankruptcy can help. Bankruptcy laws were enacted to provide debtors with relief from their creditors by giving them a fresh start. This fresh start usually comes with a high price, namely, a major hit to your credit. But bankruptcy can actually help your credit in the short and long term. How much it will hurt or help you depends on your credit scores before you file (you have more than one credit score), your financial circumstances, and other factors.

How Does Bankruptcy Affect My Credit Score?

When you file bankruptcy, your credit scores can be negatively impacted almost right away. In fact, many consider bankruptcy as having the worst impact on your credit scores compared to foreclosure and other debt collection actions. But no one knows exactly how much damage certain events, like bankruptcy, foreclosure, a short sale, or a deed in lieu of foreclosure will do to your credit. This uncertainty is due to many factors, such as:

• Credit scoring systems change over time.
• Credit scoring agencies don't make their formulas public, and your score will vary based on your prior and future credit practices and those of others with whom you are compared.
• Creditors use different criteria in evaluating consumers for credit, and these also change over time.

If you generally have good credit scores but file bankruptcy anyway, your scores will probably suffer the most. That's because the higher your pre-bankruptcy scores, the bigger the drop in your scores after you file bankruptcy. On the other hand, if you already have low credit scores, bankruptcy won't hurt your scores that badly. According to FICO, a person who has a credit score of 680 prior to a bankruptcy loses 130 to 150 points following a foreclosure. But a person who has a credit score of 780 prior to a bankruptcy loses 220 to 240 points. So, if you already have low scores and file for bankruptcy, it could potentially be easier to improve your scores post-bankruptcy.

How Filing for Bankruptcy Can Help Your Credit Scores

Even if you have high credit scores, if you find yourself in a position where you must file bankruptcy, then your credit scores probably aren't 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 get bankruptcy relief, you might find that the bankruptcy could actually help your credit, 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, a bankruptcy discharge will essentially wipe those debts clean. Debts that are discharged in bankruptcy must no longer be reported as "delinquent." Instead, these debts will typically be reported as "discharged" or "included in your bankruptcy." In some instances, this change in how the debts are reported could even boost already low credit scores.

Improving your debt-to-credit ratio. The amounts you owe on accounts make up roughly 30% of your FICO credit score. An important factor in this analysis is the percentage of your available credit that you're using. Bankruptcy might help improve your debt-to-credit ratio. This ratio is a comparison of your outstanding debt to your available credit balance. 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're normally closed or frozen when you file bankruptcy and their associated balances might be discharged. If you get a discharge for a debt with a high debt-to-credit ratio or you reaffirm debts with low balances and good credit limits, or obtain new credit accounts after your bankruptcy, you can potentially boost your FICO score because you'll 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, a bankruptcy gives you the opportunity to start over. You have another chance to get your finances right. If you budget properly and are disciplined with your money, you can lay the foundation for building a good credit history.

Following a bankruptcy, it's a good idea to start re-establishing your credit as soon as possible. You won't be burdened with the outstanding debt that you discharged in bankruptcy, and you should have more disposable income to make your remaining (or new) credit payments on time. If you establish a good track record of paying your post-bankruptcy debts on time, you can increase your credit scores. Though, it will take some time. But maybe not as long as you think; you might see some improvement as early as six months to a year after bankruptcy.

Getting Help

To learn more about credit scores and cleaning up your credit, get Nolo's Credit Repair: Make a Plan, Improve Your Credit, Avoid Scams by Attorneys Amy Loftsgordon and Cara O'Neill.

If you're thinking about filing for bankruptcy, consider talking to a bankruptcy attorney.