One of the most common questions we get from our clients is, “How will this affect my credit?” The common myth is that a bankruptcy will ruin an individual’s ability to obtain credit in the future. While the filing of a bankruptcy will have a negative effect on credit scores, many of our clients find themselves pleasantly surprised at how quickly they bounce back, and at how bankruptcy helps them get their finances back in order.
In the most cases, the credit score of someone considering bankruptcy has already taken a hit from the debt obligations which they have been unable to pay (payday loans, personal loans, vehicle payments, mortgage, medical bills, credit cards, etc.). As a result, some, most, or even all of their creditors have started reporting negatively on their credit report. The result of which is a damaged credit score.
Falling behind on these obligations will cause a credit score to take a hit, however most of my clients find that the filing of a bankruptcy stops the bleeding. Once the bankruptcy is filed, your creditors are no longer able to report to the credit bureaus. This means, that the negative reporting ceases immediately, on a go-forward basis.
The exact formulas the credit bureaus use to calculate an individual’s credit score are a closely guarded secret. However, it is common knowledge in the credit industry that a considerable portion of your credit score is made up of your outstanding debt compared to your income. Many times you hear this referred to as your “debt to income ratio.” This value represents, and somewhat predicts, an individual’s ability to repay a loan. With a host of outstanding bad debts, your borrowing future is limited. The best way to explain it is that you are considered a risky borrower if you are a millionaire with one million dollars in your bank account but have a billion dollars in debt. Despite having a million, you have several hundred millions in debt and as a result your income is already spread thin across your obligations.
With bankruptcy, however, your old outstanding debts are usually forgiven upon receipt of your discharge. Since all (or most) of your debts are gone, your “debt to income ratio” is very little or no debt and all income.
Many of our clients are shocked when they begin to receive credit card and vehicle offers soon after discharging their bankruptcy. This is typical, and is a result of the credit industry viewing you as a good bet. After all, you have just completed a credit counseling course, a financial management course, and are not eligible for another bankruptcy discharge for years. Typically your credit score after bankruptcy will be better within a year. Sometimes, it can be even better than before the bankruptcy.
A word of caution: The first few waves of offers often come with very high interest rates. Eventually, the rates will go down over time. Especially if you work diligently to improve your credit.