Bankruptcy may help struggling debtors improve their credit scores

A bankruptcy filing can be better than delinquent payments, high debt-to-credit ratios, foreclosures, repossessions or other credit score setbacks. Read on.

As if struggling with debt management didn’t pose enough challenges, there’s also the potential consequence of an adverse effect to a borrower’s FICO credit score. (Short for Fair Isaac and Co., the FICO score ranges between 300 and 850 and has become a standard adopted by major credit bureaus including Experian, TransUnion and Equifax). That, in turn, may close off credit opportunities that could otherwise help sustain a consumer through difficult times.

Some consequences of a low credit score

For example, an individual with a low credit score may not qualify for a loan without a co-signer. If a co-signer is unavailable, an individual may face a downward spiral of debt. Fortunately, there is a safety net: the federal protections of bankruptcy law.

Of course, a bankruptcy filing also impacts one’s credit score. According to a 2010 FICO report, an individual’s credit score might be lowered to the mid 500’s after filing for bankruptcy.

How a bankruptcy filing impacts one’s credit score

Yet a bankruptcy attorney would caution that there is a greater lesson to be learned. Significantly, that same FICO report estimated a pre-bankruptcy credit score in the 500’s for individuals struggling with debt management events like maxing out a credit card, missing payments, having to settle a debt with a lender, and having property repossessed or foreclosed. The FICO score is calculated based on those and other factors, such as whether a potential borrower has timely repaid past credit accounts, the level of debt held by an individual, as well as his or her credit utilization -- the ratio between the debt balance and the limit on a loan account.

For individuals who have already suffered debt management setbacks, a bankruptcy filing may actually help them improve their credit in the long term. Specifically, a bankruptcy discharges many types of debts that most likely had previously been listed as delinquent on a borrower’s credit report. In essence, the debts are included as part of the filer’s bankruptcy instead of being listed individually on his or her credit report.

After a bankruptcy filing, credit accounts with high limits are often closed or frozen. If an individual had significant outstanding debt in relation to his or her available credit balance, that debt-to-credit ratio may have accounted for up to 30 percent of a low FICO score. After going through bankruptcy, an individual may be able to open new credit accounts or even reaffirm old debts with low balances. Those accounts, with their lower debt-to-credit ratios, may result in a more favorable FICO score.

The fresh start of bankruptcy

A bankruptcy really can present a fresh start to an individual struggling with debt management and/or other types of financial difficulties. After receiving a discharge, an individual can take positive steps for rebuilding a good credit history. At a minimum, a consultation with a bankruptcy attorney can dispel fears and help educate an individual about some of the options that are available through a Chapter 7 or Chapter 13 bankruptcy filing.

Keywords: bankruptcy, delinquent payments, debt management, credit score, foreclosure