Bankruptcy: Useful Financial Tool or Financial Disaster?

Did you know that every year upwards of one and a half million Americans file for bankruptcy? Bankruptcy—the very sound of that word is enough to make most people feel a cold clutch of fear in their hearts. In others, it might induce a sense of shame. It shouldn’t cause either feeling. If you understand how bankruptcy works, it can be a useful tool in rebuilding your credit (and your life). While it will lower your credit score significantly, it can also give you a fresh start.

Power to make laws on the subject of bankruptcy is part of the U.S. Constitution. Abraham Lincoln was a bankruptcy attorney and Thomas Jefferson signed a bill repealing the first bankruptcy statute in 1801. The concept of bankruptcy dates even earlier: Queen Elizabeth I has been credited with the creation of the actual English statute to which the origins of modern day bankruptcy can be traced.

If you’re facing a mountain of debts you may feel that a bankruptcy is inevitable. But there are options for avoiding a bankruptcy:

• Slashing your expenses, however painfully, to begin paying down your debts.
• Go through Consumer Credit Counseling Services. It’s free and you can find a local chapter at nfcc.org.
• Settle your debts with your creditors. Sometimes creditors have hardship programs in which you can enroll.

Sometimes, however, there is no avoiding a bankruptcy. In 70 percent of the cases of bankruptcy filings in the U.S., poor money management is not responsible for pending insolvency – it results from unemployment, unforeseen medical expenses or divorce. If you recognize yourself in the above situations, it’s best to not drag things out. Rather than trying to keep your head above water and throwing good money after unmanageable debts, it’s best to file now so you can start saving money as soon as you are through the courts.

If you feel bankruptcy staring you in the face, you may be wondering exactly what the effects of bankruptcy will be to your credit. There are different types of bankruptcy and each affects your credit in different ways:

Bankruptcy and Your Credit

A Chapter 7 Bankruptcy wipes your debts clean. The court assigns a trustee to oversee the dismissal of your debts, verifies any saleable assets you may have, then recommends to the courts which of your listed debts are discharged. This bankruptcy will stay on your credit report for ten years.

A Chapter 13 Bankruptcy uses the courts to set up a restructuring plan for your debts. After emerging from a Chapter 13, you will still be debt free, but you will have paid back the debts through a court-monitored plan. Credit bureaus remove this bankruptcy customarily 7 years from the filing date, one of the advantages of doing a Chapter 13.

Sounds good, right?  Just go through the courts and *poof* your debts are gone. Not so fast. As mentioned, a bankruptcy will take a heavy toll on your credit score. This credit deficit lasts as long as the bankruptcy remains on your credit report. On average, a bankruptcy will lower your credit score 150-200 points, depending on your overall credit profile.  You may have difficulty getting new credit at all for the first two years after discharge.

Getting New Credit

Most credit card companies will deny your application for unsecured new accounts if you have a bankruptcy showing on your credit report. Your only option may be secured credit cards – accounts “secured” by a saving account. Secured accounts typically start with a low credit line, $300-$500, and charge high annual fees. They are not necessarily a bad idea, as long as they report your (perfect!) payment history to the credit bureaus.  You will be eligible for such accounts 6 months after being discharged from bankruptcy.  Some banks have programs that will qualify you for an unsecured card after a year of paying your secured account on time.

If you’re considering renting a home or apartment after a bankruptcy, don’t be surprised if you find that application is refused. Many of the largest apartment rental companies might not want to take a chance on someone with a bad credit history, and that’s what your credit is after a bankruptcy: bad.

You may think a past bankruptcy may make home ownership an impossibility. Fortunately, this is not correct. Did you know that as soon as two years after a bankruptcy, you may be able to qualify for a home loan? The FHA (the Federal Housing Administration) and the VA (The Veterans Administration) both include rules for accommodating prospective homeowners who have gone through a bankruptcy at two years.  Applicants must have re-established good credit and have shown that they can manage their finances.

Rebuilding Credit After a Bankruptcy

Don’t wait 6 months or two years to take action on your credit. Once you’ve gotten your bankruptcy discharge, it’s wise to begin to immediately rebuild.  The best way to get back on track is to demonstrate wise management of your money by doing things that will ultimately be reflected on your credit report.  Here are some common sense suggestions that will result in more money in your pocket, enabling you to pay your bills on time:

• Keep your spending moderate.
• Buy only what you need.
• Avoid impulse purchases.
• If you really need an appliance, equipment for your home, or a car, considering buying it used.

The most important things you can do after a bankruptcy is to open new credit (when possible) and ALWAYS pay your bills on time. Even one late pay after a BK can tank a promising credit rebuild.

It’s important to know where you stand with the credit rating agencies like Experian, Equifax, and Transunion after a bankruptcy as you attempt to rebuild your credit. The Fair Credit Reporting Act (FCRA) guarantees that you are entitled to a free credit report from each of these companies once a year, and it’s to your advantage to do this. You can access this information by visiting the annualcreditreport.com website, or by calling 1-800-322-8228. If you don’t have phone service or access to the Internet, you can also get your credit score by writing to: Annual Credit Report Request Service, P.O. Box 105281, Atlanta, GA 30348-5281, using the Annual Credit Report Request Form.

Just remember, bankruptcy doesn’t have to be end of the world as long as you learn from your past financial mistakes and take steps to manage your money in a reasoned, responsible way.