It is easily understood why a bankruptcy would have a negative impact on a consumer’s credit score, but it is also important to remember why a potential lender is reviewing your credit history. The lender wants to evaluate the risk of default or non-payment. Based on the risk, the lender may decline to make the loan, or issue the loan with a higher interest rate to compensate for the potential risk of non-payment.
Most of the time that our clients file a bankruptcy case, the damage to their credit has already been done. A credit history with slow pays, no pays, defaults, lawsuits, judgments, foreclosures and repossessions has reduced their score to the point where the borrowing options are limited, and when available, the repayment terms are burdensome. Filing bankruptcy at this point is not going to worsen your score, but is going to relieve you of the harassment from collection and garnishments.
So how can a discharge in bankruptcy improve your credit? There are additional factors that lenders consider in which a bankruptcy filing will actually reduce the likelihood of non-payment.
1) By discharging your other debts, you are reducing your debt-to-income ratio. You have “wiped out the competition”, so a new lender does not have to worry about competing with multiple other creditors for a limited amount of funds.
2) Likewise, a potential lender does not have to worry about the consumer being unable to repay the new loan because of a wage garnishment, since any judgments and garnishments would be discharged.
3) The possibility of a bankruptcy filing is also a factor that a lender will consider when evaluating a consumer for a loan. Because there are time restrictions with respect to the filing of another bankruptcy (for instance, 8 years have to elapse before a consumer can receive a discharge in another Chapter 7 case), the prospect of the loan being discharged in a subsequent bankruptcy is lessened considerably.
4) Debtors are required to participate in credit counseling, both before and after the filing of their bankruptcy case. The intent of Congress in establishing this requirement was to allow debtors to exit bankruptcy with more knowledge about financial management. As a result, lenders expect that borrowers who have filed a bankruptcy will be better prepared to handle their financial obligations going forward.
By no means is our firm encouraging people to file a bankruptcy as a means of “credit repair”. But at the same time, it is important to educate consumers as to what to expect after their cases have been discharged. There is life after bankruptcy, and the lessons learned through the bankruptcy process can make you a more knowledgeable and cautious borrower going forward.