Most of my clients are surprised when I tell them their credit score may go up when they file bankruptcy. In fact, one of the Top Two Fears of Bankruptcy I hear from clients is the negative impact it’ll have on their credit scores. This is the case especially for renters since so many property management firms and landlords check credit scores of potential tenants before renting to them. (The other Top Fear is that the person will lose everything in bankruptcy – they won’t). For my clients who are discharging primarily credit card debt in their chapter 7 bankruptcy (as opposed to tax debt), their credit score almost always improves in the first few weeks after their bankruptcy petition is filed. How can this be?

Why Filing Bankruptcy Can Improve Credit Scores

All the credit cards of a person filing chapter 7 bankruptcy are closed within hours of a bankruptcy being filed. What’s mechanism that makes this happen? When a debtor files bankruptcy, the U.S. bankruptcy court includes their name and social security number on a list that is sent to all financial institutions and credit rating agencies. Credit card issuers immediately close the accounts of anyone on the list of new bankruptcies because they do no want to lose more money (after all, the balance on those cards is exactly what will be wiped out by the bankruptcy).

The credit agencies note these credit card closures on the credit reports of people who file bankruptcy, and also adjust their credit scores. Recall that a person’s credit score consists of five components: Payment History (35% of score), Amount Owed (30%), Length of Credit History (15%), New Credit and Credit Mix (10%) each. Filing bankruptcy vastly improves the Amount Owed Category by taking it down to $0. And, since this category constitutes 1/3 of a person’s credit score, the numerical impact on their score can easily top 100 point. In short, bankruptcy removes the large balances on credit cards that were weighing down the debtor’s credit score. This isn’t to say that filing bankruptcy is all good news for credit: it will be somewhat harder and more expensive to get credit for a while following the bankruptcy filing. But it’s not entirely bad news, either.

More good news: absent the debtor building up big credit card balances and late payments again, the increase to their credit score is likely permanent. 

Are you swamped by debt? Afraid of filing bankruptcy? It may not be right for you, but call me to at least learn about how bankruptcy can both help and hurt you.

July 28, 2023

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