Written By: Al Bingham
Bankruptcy impacts a credit score more than any other singular event in a credit report. While the bankruptcy itself is a key factor adversely affecting credit scores, other sub-components also play roles in determining a credit score. An estimated 35 percent of a FICO® credit score is Payment History, which is measured by several sub-factors, including a bankruptcy. Understanding how the many issues resulting from a bankruptcy filing impact a credit score can help consumers, and perhaps your clients, rebuild their scores.
Before pursuing a bankruptcy, a consumer should better understand the six primary payment history issues that lower a credit score:
- Each loan with a late payment becomes a derogatory account.
- Any balances on derogatory accounts will lower credit scores. A person typically has several derogatory accounts with balances before they file for bankruptcy.
- How recent is the most recent late payment? For bankruptcy filers, it is usually within the last month.
- There is usually an elevated amount currently past due from missed payments.
- Payment history also looks at the greatest derogatory event in the credit report. The levels of delinquency that lower credit scores are:
- A 30-day late payment is the first level of delinquency.
- Seriously past due late payments are considered a second level delinquency and could easily drop credit scores 60 to 80 points.
- A collection, judgment, tax lien and a bankruptcy are considered a third level of delinquency and the drop to credit scores could be anywhere from 100 to 225 points.
- Following a bankruptcy, the bankruptcy becomes the greatest derogatory event. The higher the delinquency level, the lower the credit score.
- The time from a derogatory event is a substantial factor in credit scores. A recent bankruptcy filing will lower credit scores more than if the event occurred six years ago.
All of these six factors determine the overall impact to credit scores from Payment History.
Oftentimes, a Chapter 7 bankruptcy will actually improve a consumer’s credit scores immediately after the discharge by resolving a couple of issues. Unsecured accounts will generally go from having amounts past due and balances on derogatory accounts to having no balances with nothing past due. The consumer, who ultimately completes their Chapter 7 bankruptcy, can update these accounts by sending a copy of bankruptcy papers to the three major credit bureaus and highlight the accounts discharged in the bankruptcy.
A Chapter 13 bankruptcy, on the other hand, will usually not immediately raise a person’s credit scores. The past due amounts and derogatory account balances will often take a couple of years to be paid off through a Chapter 13 bankruptcy.
After the initial increase in credit scores from clearing the balances and amounts past due on those accounts in a Chapter 7 bankruptcy, scores will generally not see any dramatic improvement for the coming months and years. Everything considered resolved and equal, scores will generally improve roughly 12 to 20 points a year until the bankruptcy falls off the credit report; seven years for a Chapter 13, and 10 years for a Chapter 7. The improvement in credit scores post-bankruptcy will largely depend on what other open accounts are in good standing, and how long they have been open.
There are three additional points to understand. Even if payments on a mortgage or an auto loan are made on time throughout the bankruptcy process, the Court/Trustee will usually send a bankruptcy notice to such lenders. As a result, lenders will often change these accounts from a satisfactory account (even if payments have been made on time) to a derogatory account. Second, even if a bankruptcy has been dismissed, the impact on credit scores will be the same as a discharged bankruptcy.
Finally, if there are additional seriously past due late payments after the bankruptcy, the delinquency level will be raised to the fourth level (if it hasn’t been reached already). I call this the “Black Hole.” This will lower credit scores further until late payments or bankruptcy drop off the credit report.
It is imperative for consumers to build their credit scores by avoiding additional late payments after a bankruptcy. This will help build credit scores higher and quicker following a bankruptcy.
Al Bingham is the author of The Road to 850. His third edition of his book, The Road to 850: (The Rules Keep Changing) will be out January 2016. He can be reached at firstname.lastname@example.org.