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Posted by: Rob Cohen
When you’re in debt and trying to decide what action to take, you may be concerned about how to protect your credit score.
That’s often one of the last barriers to deciding to file for bankruptcy – what will this do to my credit?
The answer may surprise you. Bankruptcy certainly does have an effect on your credit score, but it’s not nearly as bad as you might expect.
Credit score basics
Each of the three major credit reporting agencies maintains a credit score for every person who uses credit. These scores run from 300 up to 850. All three scores are based on the FICO score system. “FICO” is an abbreviation of “Fair, Isaac and Co.,” the California company that invented the system. That is why you will sometimes see the credit score referred to as a FICO score.
This post will not only consider bankruptcy’s impact on credit, but also two additional debt relief actions and their effect on your credit score. We will cover credit score effects of:
- filing bankruptcy under Chapter 7 or Chapter 13 of the Bankruptcy Code;
- debt consolidation;
- and debt settlement
Chapter 7 and chapter 13 bankruptcy and your credit
Both Chapter 7 and Chapter 13 are common forms of consumer bankruptcy. Under Chapter 7, the debtor generally does not pay anything bank to his or her creditors. Under Chapter 13 the debtor pays some or all of the debts back; Chapter 13 filers can pay anywhere from 1 percent up to and including 100 percent of the debts. The amount being paid back depends of the debtor’s income and other factors. Because most Chapter 7 filers pay nothing to creditors, most people prefer to file under Chapter 7. However, not everyone qualifies for Chapter 7 protection. If your income is above a certain level, you may be required to file under Chapter 13 and pay something back.
Both Chapter 7 and Chapter 13 are going to affect your credit score in similar ways. Most filers end up with a score in the mid-500s.
Higher starting scores take a bigger hit than lower ones.
For example, a high credit score of 780 will probably go down to around 540, a drop of 240 points.
A lower score, such as 680, will go down to around 530, a drop of only 150 points. In any case, most people land in that mid-500 range.
Before you write off bankruptcy as an option because of the effect on your credit, consider that your score already takes a hit whenever you miss a payment. Most people considering bankruptcy already have lower scores.
After bankruptcy, you can immediately start to rebuild your credit. You may want to take out a secured credit card or a store credit card (these are easier to get than standard credit cards) and use them regularly to make small purchases. Pay off your account in full, on time, every month. Your credit will build up quickly. However, keep in mind that a bankruptcy will remain on your credit report for 7-10 years, so lenders and other financial institutions will take it into account when extending you credit.
When you consolidate your debts, you lump them all together so that you only have to make one manageable payment every month. Unlike in bankruptcy, you’re going to pay all your debts back. In typical debt consolidation arrangements, a debt consolidation company will intercede for you with your creditors and arrange for a manageable payment for you to make each month on your debt. You’ll make your payment to the debt consolidation company and they’ll send the appropriate portions along to your creditors. Debt consolidation plans may be useful when you fell behind because of a crisis and can’t get back on track because the creditors demand that you make up the missed payments all at once.
These plan only work if you have enough income to pay all of your debts back. It will take several years to complete the plan, during which time you will have no use of your credit cards. This type of arrangement will affect your credit score because you technically won’t be in compliance with your obligations to the creditors. After you finish the struggle to pay off your debts, the effects will stick with your credit score for years to come.
Debt consolidation usually has a more severe effect on your credit than bankruptcy, especially in the long term. With bankruptcy, you can start rebuilding your score right away. With debt consolidation, your score is going to stay low for a long time.
Debt settlement is sort of like a middle road between bankruptcy and debt consolidation. You won’t get all the legal protections and rights of bankruptcy, but you won’t have to pay off all of your debt. In a standard debt settlement situation, you make a monthly payment to a debt settlement company. That company puts your money in a separate account, sometimes called a “war chest.” That money will stay in that account, building up every month. When your war chest is big enough, the debt settlement company will write to your creditors. In that letter, the debt settlement company usually informs creditors that it’s handling your debts and that you’re willing to pay off those debts, but only with a steep discount. The debt settlement company will usually aim for payment of 30-40% of the total debt.
The creditors will not quickly agree to such terms, but as time goes by, some may eventually agree to take 50 percent or less, forgiving you of the remainder of the amount due. The debt is then settled and you owe that creditor no more. The debt settlement company has to try and do this with each of your creditors, and it can take many months or even a couple of years.
Remember that creditors are not under any legal obligation to work with the debt settlement company or settle your debt. Some creditors will absolutely refuse to work out such settlements and will continue collection activity, including eventually suing you. There are also scam debt settlement companies preying on debtors; they’ll charge you big fees and take your war chest payments and then disappear, leaving you far worse off than you were before.
Debt settlement is not only difficult to pull off, it’s extremely hard on your credit score. You’re paying into your war chest every month rather than making payments on your debt, meaning that your credit score is taking continual hits because your file shows missed payments every month.
If your debt settlement attempt fails, you’re stuck with an even lower credit score than before. If your attempt succeeds, your credit report will show that you paid those debts for less than full value. That has a serious impact on your credit score because it’s treated as if you didn’t pay at all.
The Bottom Line
If you’re struggling with debt and considering your options, don’t avoid bankruptcy because you’re afraid of its effect on your credit score. Once you start missing payments, your score is already suffering. The sooner you get help with your debt, the sooner you can start to rebuild your score. In many cases, bankruptcy is actually easier on your score than debt consolidation, which takes years during which your credit will continue to drop, or debt settlement, which will knock down your score without any sort of guarantee that your debt will actually be settled. Bankruptcy exists to help you get your financial life back on track with the protection of the law. Before you make any decisions about how to deal with your debt, speak to an experienced debt counselor or bankruptcy attorney about your financial situation. They’ll help you determine the best option given your situation and your financial goals.
Rob Cohen, the Managing Partner of Cohen & Cohen P.C., is a bankruptcy attorney that practices in Colorado and Wyoming. He serves as a Chapter 7 Bankruptcy Panel Trustee, and has to date administered over 8,000 Chapter 7 bankruptcy estates. Rob is a Certified Consumer Bankruptcy Specialist, and was nominated for Denver Business Journal’s 40 under 40 in both 2014 and 2016.