An email from a new client:
Hi Sam! Thank you for your time yesterday. A few quick questions for you.
- After my case is filed, and everything goes through, how long does it take for my credit to repair/refresh?
- What are most of your clients seeing?
- Can I expect to have an industry average credit score within 3 years?
Credit comes back in phases. Right now his credit is in the gutter and the score has nowhere to go but up. In fact, most debtors have a higher credit score one year after filing bankruptcy than on the day they filed.
That’s right, filing bankruptcy may cause your credit score to go up. Hold on, I thought bankruptcy ruined credit? Why would filing bankruptcy be good for your credit?
When we refer to credit scores, we are generally referring to your FICO Score created by the Fair Isaac Corporation. A score below 580 is considered poor and a score above 670 is considered good.
Initial credit score hit followed by positive reporting
In truth, filing bankruptcy usually causes a credit score to drop initially. And the higher the score is on the day a case is filed, the harder the hit.
But, most people file bankruptcy after they have already maxed out and defaulted on credit card accounts. They file bankruptcy after receiving a court judgment. The credit score is already down so the hit they take is not significant.
Once the initial credit score hit takes place the negative reporting stops. It’s like putting a bandage on an open wound. The blood stops flowing and the credit wound begins to heal. Now the foundation for positive credit reporting is in place.
Ironically, filing bankruptcy may make it easier to get a loan
Many find it easier to get loans after bankruptcy than before. In fact, some bankers send me clients to clean up the bad credit issues so they can actually extend a new loan.
That may seem strange, but think about this for a minute. If you were a banker, would you prefer to extend credit to a person on the verge of filing bankruptcy or to a person who just walked out of Chapter 7, who is debt free and who cannot file another Chapter 7 for eight years? Who is the better risk?
A credit score is supposed to tell a banker the likelihood that a person will repay a debt, and a person with no debt is a better risk than a person who is deeply in debt.
Thirty percent of a credit score is based on the Debt-to-Income Ratio. If you owe $5,000 of debt on a $100,000 annual salary, your debt-to-income ratio is 5%, which is very low. But if you owe $10,000 on an annual income of $20,000, then the ratio is 50%, which is very high.
Bankers focus heavily on debt-to-income ratio when reviewing loan applications.
The number one thing you can do to increase your credit score is to pay down debt. That is why bankruptcy actually improves the credit score–because the debt-to-income ratio immediately improves.
Some rebuild credit quickly after bankruptcy as they continue to pay existing car or home loans, and those payments get scored positively. Others stop using all credit after bankruptcy and just use cash, which is fine, but the result is that nobody is scoring their use of credit, so the score stays low.
If you want to build credit after bankruptcy you must use credit. Some clients obtain secured credit cards to rebuild their credit score. Paying off auto loans after bankruptcy helps. Paying down student loans helps. Paying down any debt after bankruptcy helps.
Paying credit card bills early in the billing cycle helps the score. Not only do they score if you pay a debt on time, but when you pay the debt.
Bankers prefer customers who pay loans the day the bill arrives in the mailbox over customers who pay 2 seconds before the bill is late. Those who pay after a due date incur late fees and that is a sign of a risky loan to a banker.
Studies show that early payers tend to default less and late payers tend to default more. So, pay bills early in the bill cycle and watch the credit score go up.
Focus on the Cash Score, not the Credit Score
Credit scores really only matter if you need to borrow money, like buying a home. Otherwise, instead of focusing on the credit score, focus on the cash score. How much did you save this month? Do you have 3 months of expenses saved in cash? Have you made saving cash systematic?
Unfortunately, our credit scoring models do not account for cash savings, but those who store cash reserves are prepared for unexpected events and default less.
Buying a home after bankruptcy
As a general rule, you must wait two years after filing Chapter 7 to qualify for a FHA home loan.
Those debtors in the middle of a Chapter 13 case must wait at least one year and be able to prove that they have made all bankruptcy payments on time. In addition, a debtor must obtain court approval to incur a mortgage debt during a Chapter 13 case.
Car loans after filing bankruptcy
It used to be that a debtor had to wait for the Chapter 7 discharge to obtain a car loan. That has all changed in recent years. Now, some are getting car loans a day after the case is filed. It appears that the auto lending industry has finally figured out that those entering Chapter 7 are better credit risk since they emerge debt free and cannot file another Chapter 7 for eight years.
Filing bankruptcy does not block access to credit. In many cases it actually increases the ability to borrow. Some waiting periods apply to obtain certain types of credit, but generally a person files for bankruptcy to start building good credit, not to destroy it.
Filing bankruptcy can accelerate the process of building better credit.
Image courtesy of Flickr and eflon