Bankruptcy is the most negative derogatory event for a borrower. For creditors, a bankruptcy filing clearly indicates: the debtor was not creditworthy in the past and did not pay his or her debt obligations.
This intuitive loss of creditworthiness does indeed translate into the quantitative assessment of the borrower’s reliability, the credit score. Experts, including those at FICO, the company that pioneered the most widely used personal credit measure, the FICO score, agree that the impact of bankruptcy on the credit score will be significant, a drop of 100-300 points.
When trying to understand the impact on a bankruptcy on the credit score, borrowers are especially interested in three key questions: how much their score is expected to drop, how low it can go and how long before they can recover or establish good credit again.
Unfortunately, none of these questions can be answered with accurate numbers. The lack of quantifiable answers is partly because there is a plethora of credit score models used by the various agencies, banks, credit bureaus that are all slightly different and – more importantly – work with protected and secret algorithms. At the same time, credit score models are extremely complex mathematical and statistical models driven by a huge number of factors, so the actual impact of any single factor – such as bankruptcy – depends on the levels and combinations of the other factors, as well. Therefore, what may be a 300-point drop event for one borrower with one set of circumstances may turn out to be a 120-point slide for another one with a completely different set of characteristics.
How much will the credit score drop?
The range between 100 and 300 points has been frequently quoted as the most probable indicator of the expected hit. The interesting question is what causes the drop to be bigger rather than smaller.
Intuitively, the frequently provided explanation that borrowers with a lower pre-bankruptcy score can expect a smaller decrease than those with higher initial scores makes sense. FICO scores, or any other credit score for that matter, can only move within a defined closed range: between 300 and 800 in FICO’s case, putting a floor under all debtors.
Within the not fully articulated, yet somewhat known logic of the scoring system, this is predictable, as well. A higher credit score assumes long, well-established borrowing histories, with optimal mixes of various types of credits and close to impeccable record for accounts in good standing. A bankruptcy filing wipes out all these positive indicators, so the credit score will be hit not only by the actual bankruptcy filing, but also by the elimination of these score enhancing items, as well.
Borrowers with already low credit scores due to delinquent accounts, short and blemished loan histories, high debt-to-income ratios do not have many positive attributes to lose in the bankruptcy, so while the derogatory item itself will decrease their score, there will be much less collateral damage for them. In fact, as the bankruptcy starts getting farther away in time, the elimination of the delinquent and late payment histories in bankruptcy can provide a smoother foundation for rebuilding.
The size of the impact also depends on the type and scope of bankruptcy, which can be an important issue to consider, especially for higher score borrowers. A Chapter 13 filing that reorganizes at least some of the debtor’s obligations into smaller, manageable amounts establishing new repayment schedules has a smaller and shorter-term impact than a Chapter 7 liquidation of substantially all debt, as Chapter 13 keeps the borrower in a ‘debtor’ status with the continued renegotiated debt repayments providing an opportunity to prove creditworthiness.
How much can the credit score be with a bankruptcy on record?
There are no hard numbers available for this question, either. According to Experian data from 2005, the average credit score of people with bankruptcy records was around 70 points lower than the average for all borrowers: around 600 compared to 670. The average rating of 600 includes borrowers whose bankruptcies may have been several years ago.
Immediately after bankruptcy, the score will be low. Moreover, bankruptcy is an especially ‘sticky’ event that will have a long-lasting impact staying on record for up to 10 years.
However, there is an important aspect of the popular scoring systems that receives little attention. Most models, including FICO’s, group borrowers into categories or score cards defined by significant, key factors. Credit score evaluators group borrowers impacted by bankruptcy into one category. Within each category, the final scores are assigned by comparing group members on a relative basis, to each other, on the various key risk factors.
Consequently, the more favorably a specific bankrupt debtor looks relative to other people in the same group, the higher their final rating will be. While borrowers with fresh bankruptcies will initially share many key risk profile features such as no debt, no credit history, no good or bad payment pattern, no inquiries, these will not be differentiating factors for the first year or two after bankruptcy. The sooner a borrower can reestablish credit and maintain a good standing, the sooner he or she will start ‘rising’ relative to the other debtors in the damaged credit group. This also explains at least partially the relatively more limited damage of a Chapter 13 bankruptcy. Through the satisfactory servicing of their restructured obligations, Chapter 13 filers can demonstrate good payment behavior.
While borrowers with a recent bankruptcy will be naturally more reluctant to use debt again, rebuilding a small, but well-maintained portfolio of credit lines is important for reestablishing good credit for future use, if it becomes necessary. At the same time, debtors with bankruptcy should be even more careful with missed and late payments for newly established loans as the implications can be more severe in the bankruptcy group than in less risky, more creditworthy categories.
Finally, another less well-known set of factors used in credit ratings is important to remember. Most credit rating agencies use an extensive set of non-financial indicators in their assessment, such as length of employment, profession, home ownership, length of residence and age. Obviously, these attributes are largely outside of the immediate control of borrowers and are very difficult to change, if at all. They do play an important role in the final ratings of ‘average’ customers without bankruptcy records, as well, but for debtors in the damaged credit group they can become even more significant as this group has less differentiating debt and financial management related factors in the light of their members’ limited access to credit.
How long will bankruptcy affect the credit score?
Bankruptcy filing will remain on record for credit evaluations for up to 10 years. However, as with most derogatory events, its impact on the score will ‘wear off’ with the passing of time. As borrowers start to rebuild their credit and accumulate positive items such as consistent timely payments, growing credit histories, acceptable size and mix of debt, their credit score will start increasing. The general expectation is for Chapter 7 bankruptcies to keep borrowers in credit-deprived categories for 2 years as a minimum, while Chapter 13 filers may be able to improve their score within one year.
Borrowers with very low pre-bankruptcy scores in the 400-500 range can recover and even surpass their original scores within a year, but debtors who fell from 700+ heights may take 5 years or longer to reclaim their high ratings.
Rebuilding after a bankruptcy
Ironically, though not unexpectedly, borrowers with already bad credit can expect to take a smaller and shorter lasting hit from filing for bankruptcy. However, for them, too, the bankruptcy clean sweep freeing them from the burden of their debts may come at the high price of the loss of all their accumulated valuable assets.
Filing for bankruptcy should not be taken lightly as it is a truly ruinous event on personal finances with long-lasting implications. However, if it turns out to be unavoidable, filers should use the clean slate in their credit histories wisely to rebuild a healthy credit. A solid credit score is necessary not for the purposes of indiscriminate debt use, but as a safety net to be used to complement carefully built up savings in the case of emergencies or for necessary long-term investments in their and their families’ future.