How will bankruptcy affect my credit?
By Eva Norlyk Smith Ph.D.
April 21, 2014
If I owe a large amount of money but want to buy a house (get a mortgage), will it destroy my credit if I declare bankruptcy? –P.C.
To answer that question, put yourself in a lender's shoes. Let's say one of your friends borrowed a large sum of money from some of your acquaintances. You heard through the grapevine that he didn't pay the money back, declared bankruptcy, and walked away from the debt.
Now that same friend wants to borrow money from you, because he wants to buy a house. Would you lend him the money?
I thought not. Since he has already walked away from a large debt, chances are that he will do the same to you.
This is, in essence, how credit scoring works, just on a larger scale. Credit reports keep track of who borrowed money from whom, and who paid it back and who didn't. The idea is that people tend to follow a pattern of how they handle money — if someone gets in over his or her head in debt once, chances are it will happen again.
There are a few big sins when it comes to handling debt, and many small ones. And, like it or not, credit reports keep tabs on all of them. They create a record of how each of us handles the loans and credit cards we take on, and reward or punish us accordingly.
Small sins include paying bills late or missing payments, borrowing too much in relation to how much credit you have available or applying for credit often. These kinds of activities will lower your credit score, but they won't sink it completely.
What will kill your credit score is walking away from a debt, either by stopping payments or — you guessed it — declaring bankruptcy.
The degree of impact depends on what your credit report looks like. For someone with stellar credit and a high FICO score, the drop in points will be considerable. Someone whose credit is already bad may see their score drop less in terms of points, but that's just because there's not so far for it to drop. Also, if multiple credit accounts are included, the impact will be higher than if it's just one or two.
The effects of the bankruptcy on your credit score will decrease over time, so you can rebuild credit before 10 years are up. In fact, the sooner you begin, the faster your credit score will rebound. The best way to rebuild credit after bankruptcy? Get a secured credit card and make timely payments, gradually expanding into larger credit lines and more credit cards as your credit improves.
Still, it takes years to re-establish good credit after bankruptcy, and even longer before potential mortgage lenders will consider you for a loan. So, if you have the choice, better to take the time to pay off your debts and enjoy the improvements to your credit score that will come with that. And once you reach that goal, you will see doors open that previously were closed to you.
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