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 major 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 credit score, financial circumstances, and other factors.
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 score—range from 300 to 850. A FICO score is based on the information in your credit report, including:
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.
When you file bankruptcy, your credit 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. But no one knows exactly how much damage certain events, like bankruptcy, foreclosure, a short sale, or deed in lieu of foreclosure will do to your credit. This is due to many factors, such as:
If you have a good credit score, but file bankruptcy anyway, you will probably suffer the most. That is because the higher your pre-bankruptcy 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 score 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 a low score and file for bankruptcy, this could potentially make it easier for you to improve your score post-bankruptcy.
If you find yourself in a position where you must file bankruptcy, then your credit 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.
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. The amounts you owe on accounts makes 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 are normally closed or frozen when you file bankruptcy. But 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.
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.
Following the bankruptcy, it's a good idea to start re-establishing your credit as soon as possible. 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 on time, you can increase your credit score over time. This might 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.)
If you’re thinking about filing for bankruptcy, consider talking to a bankruptcy attorney.