Bankruptcy and Credit: To File, or Not to File

There’s no question that bankruptcy is a negative on your credit report. A Chapter 7 bankruptcy case stays on your credit history for 10 years, and a Chapter 13 case for seven. It will come as no surprise that most creditors don’t love to see bankruptcy when they’re reviewing your credit report.

That said, the impact of a bankruptcy filing on credit scores differs significantly depending on your starting point—an important piece of the puzzle that is often overlooked when people offer generalized advice about bankruptcy and credit.

Filing for Bankruptcy with a High Credit Score

Although the general statement that bankruptcy hurts your credit score is widespread, one source of this concern is a widely-quoted hypothetical from the Fair Isaac Corporation (creators of the FICO score). Obviously, they know how credit scores work, so when they told the world that credit scores could be expected to plummet after a bankruptcy filing, it was easy to take them at their word.

However, the two hypothetical cases often referenced to show this significant decline were based on starting credit scores of 780 and 680. A 780 credit score is excellent, so it’s not a big surprise to learn that someone with a very strong positive credit history would see a big drop-off after filing bankruptcy. In the example provided, that decline was 220-240 points, bringing the score down to the mid-500s.

The hypothetical consumer who started with a solid-but-not-excellent 680 lost 130-150 points, also bringing his score down to the mid-500s.

But, the examples ended there, with the impact of bankruptcy on a good to great credit score. And, while there are exceptions, the vast majority of people seriously considering bankruptcy don’t have good to great credit scores. In fact, in many areas a small percentage of consumers reach these scores. 2017 Experian data shows that Mississippi residents have the lowest average credit scores in the country, with Alabama and Georgia tied for third-lowest.

Filing for Bankruptcy with a Low Credit Score

Fortunately, we have a big of data from other sources about the more realistic and relevant impact of bankruptcy on the credit scores of people who are struggling with past-due balances when they file for bankruptcy protection—or don’t.

The Federal Reserve Bank of Philadelphia analyzed data from Equifax to track the impact of bankruptcy on those who file for Chapter 7 or Chapter 13 bankruptcy in 2010. The result was surprising to many: both Chapter 7 and Chapter 13 filers saw a significant jump in their credit scores shortly after discharge. For Chapter 7 filers, the average increase was just over 82 points, while those receiving a Chapter 13 discharge saw an average increase of about 75 points.

Why are these outcomes so different from those set forth in Fair Isaac’s hypothetical models?

At least in part because the real bankruptcy petitioners studied didn’t typically have credit scores of 780, or even 680. The average pre-filing score for Chapter 7 petitioners was 538.2, and Chapter 13 filers had a slightly lower average score.

To File or Not to File?

A few years later, the Federal Reserve Bank of New York took the analysis one step further, comparing credit score trends of insolvent debtors who did and did not file for bankruptcy. In the time period studied—1999 to 2011—credit scores for insolvents who had filed for bankruptcy protection were consistently higher than those for insolvents who had not. For example, in the first quarter of 2011, average credit scores for bankruptcy filers hovered above 620, both one quarter and four quarters after bankruptcy. Those who didn’t file, on the other hand, posted average scores of about 550 after two quarters and about 570 after four.

Similarly, those who filed bankruptcy after reaching the point of insolvency were consistently more likely to have been extended new lines of credit one year later.

Of course, there are many factors that play a role in the determination of a consumer’s credit score, and many factors that impact the decision to file for bankruptcy protection. However, the New York Fed concluded that as a general rule, filing for bankruptcy would likely be preferable for an insolvent debtor.

In 2017, another report from the same institution affirmed that bankruptcy petitioners have typically seen a significant decline in credit scores in the year leading up to bankruptcy, followed by a partial rebound after. A long-term analysis showed that scores continued to increase across the 60 quarters (15 years) after bankruptcy, although the progress isn’t perfectly linear. Successful Chapter 7 and Chapter 13 filers each saw a small bump when the bankruptcy dropped off of their credit reports.

The Bottom Line about Bankruptcy and Credit

The bottom line is that the impact of bankruptcy on your credit score depends on a variety of factors. For those already struggling with debt and seeing a decline in credit scores as debts are reported delinquent or passed to collection agencies, bankruptcy may have a positive impact in the short term as well as the long term.

Like most bankruptcy-related and other legal issues, there is no cookie-cutter answer, and general news reports aren’t necessarily a good source of information about your specific situation. Scheduling a free consultation with a local bankruptcy attorney is a great way to obtain information and guidance tailored to your circumstances.

Contact us to get started right now.