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Friday, October 3, 2014

Bankruptcy and its Impact on Credit Scores and Access to Credit (Part II--Credit Scores)

In my last post, I covered the derogatory payment history information that can find its way into a credit report, and how long it can stay there.  As I described in more detail in that post, bankruptcies will stay on a credit report for 10 years after you file and missed payments will stay on the report for 7-7½ years.  This is important to know because, as long as these negative items are on a credit report, they are fodder for negatively impacting a credit score.  In this post, we'll try to get a handle on just how big an impact a negative payment history has on the credit score.

I.  Which score matters most?

In the earlier post I said there's no such thing as one, omnipresent credit score that is used by all creditors in all situations.  That was accurate as far as it goes, but in reality the FICO scoring formula is, by far, the most commonly used.*  Given the overwhelming importance of FICO scores, I've limited my discussion below to FICO scores, though other, less widely-used scoring products no doubt follow similar patterns.  

II.  What is the purpose of a credit score?

As mentioned in the previous post, the credit score is supposed to provide a numeric value that will enable a potential lender to assess a borrower's risk of default.  More specifically, most scoring models are supposed to provide an assessment of the risk of default in the next 18-24 months.  The "classic" FICO scoring scale goes from 300 (highest risk of default) to 850 (lowest risk of default).  

III.  How does the FICO Score treat derogatory events like defaults and bankruptcies?

According to FICO, the largest factor in the scoring model (35% of the total) is, unsurprisingly, a person's "payment history."  This is where payment delinquencies, settled debts, foreclosures and bankruptcies come into play.  

The good people at FICO have been nice enough to provide a hypothetical comparison of two people (one with a very good score and one with a more mediocre score), and how each of their scores fared after various negative credit events.  

According to these hypothetical scenarios, a person with a credit score of 780 could expect a drop to:  (i) 670-690 with one 30-day delinquency on one credit account, (ii) 655-675 after settling one credit card debt, (iii) 620-640 after a foreclosure, and (iv) 540-560 after a bankruptcy.

By contrast, a person with a credit score of 680 could expect a drop to: (i) 600-620 with one 30-day delinquency on one credit account, (ii) 615-635 after settling one credit card debt, (iii) 575-595 after a foreclosure, and (iv) 530-550 after a bankruptcy.

IV.  What does this mean for people considering bankruptcy?

For people who are contemplating a bankruptcy (namely, people who have probably already defaulted on multiple credit accounts, or are expecting that they will soon have to do so because of difficult financial straits), I think FICO's hypothetical scenarios make a few things clear:
  1. Simply one 30-day delinquency on one account results in a 60 to 110 point drop for debtors with these credit profiles.  By contrast, a bankruptcy will result in a 130 to 240 point drop for these same debtors.  This means merely being 30 days late on one account has almost half the effect of a bankruptcy filing (at least in the short term).
  2. This hypothetical also shows that, if you've missed multiple payments lately, your credit score has probably already taken a substantial hit (undoubtedly much more than the 60 to 110 points projected for being 30 days late on just one account).  For a person desperate enough to be contemplating bankruptcy, the alternative (default on multiple debts) doesn't promise much of a credit score improvement over a bankruptcy.  
  3. On a related note, the hypothetical shows that people with higher credit scores suffer a bigger "hit" to their score with a bankruptcy--about 90 points worse for the person with the stronger score.  In fact, on a different page, the FICO website makes this point explicitly: "[S]omeone with many negative items already listed on their credit report might only see a modest drop in their score [as a result of a bankruptcy]." 
People under acute financial distress and contemplating bankruptcy rarely have high credit scores, so their credit score hit from a bankruptcy will not be anywhere near as large as it would be for someone with pristine credit.
The FICO site also alludes to another aspect of a bankruptcy's impact on a credit score when it says that "the more accounts included in the bankruptcy filing, the more of an impact on your score."  Since default on more than one account is much worse for a credit score than default on just one account (and defaults on larger accounts are worse than defaults on smaller accounts), it's unsurprising that a bankruptcy involving the discharge of many debts would be worse than a bankruptcy discharge of just a few debts.

V.  Is a Chapter 7 more or less detrimental to a credit score than a Chapter 13?

In the last post I wrote that the FCRA requires the CRAs to report which chapter of bankruptcy relief a person files under, so it must matter for purposes of calculating a person's credit score, right?  Apparently not.  The FICO website says that their scoring system treats Chapter 7s and Chapter 13s as "having the same level of severity" because their "research has found both types [of bankruptcy] to be similarly predictive in assessing future creditworthiness."  (I find this statement surprising, but we have no choice but to take them at their word.)

Therefore, to the extent a person contemplating bankruptcy is trying to decide whether a Chapter 7 or a Chapter 13 is right for them, the impact on their credit score need not be a consideration.

VI.  Summing Up

Near-term credit score considerations are rarely a factor for people contemplating bankruptcy, since people generally don't even consider a bankruptcy unless they're already in a position where they feel that they are unable satisfy their debts.  People who have been able to maintain a higher credit score despite struggling with debt have more at stake than those who have already defaulted on multiple accounts, but even these people need to make a sober assessment of whether they have any reasonable likelihood of retiring their debt in the future without being delinquent (or deferring critical home and car maintenance, retirement savings, etc., which are, after all, much more essential to long-term financial security than a solid credit score).

As described above, a bankruptcy filing pretty much guarantees a credit score in the 500s in the immediate aftermath of the filing.  But how long does that last?  In the next post, I'll address the somewhat more nebulous issue of how long it takes to resurrect a credit score after a bankruptcy.

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* For example, the Consumer Financial Protection Bureau, citing industry sources, estimated that 90% of the credit scores sold to lenders in connection with credit-related decisions in 2010 were sold by FICO.  In addition, Fannie Mae and Freddie Mac require mortgage originators (banks and other lenders) to use the "classic FICO score" in making credit evaluations if they wish to sell mortgages on the secondary market through Fannie or Freddie.  Moreover, the Federal Housing Authority uses FICO scores in connection with loans that are going to be insured through the FHA.

Monday, September 22, 2014

Bankruptcy and its Impact on Credit Scores and Access to Credit (Part I--Credit Reports)

I get a lot of questions from clients about how a bankruptcy will affect their credit score.  It is at this point when I am typically forced to give a frustratingly vague answer: "It depends," or its even more aggravating cousin: "It's complicated."

Since I recognize that these are wholly unsatisfying responses, I've decided to dedicate the next few blog posts to the issue of credit reports, credit scores, the effect of a bankruptcy on credit scores, and its potential impact on access to credit and the interest rates at which people can borrow.  As I said, this is a complicated subject.  It's complicated for two reasons: (1) because the credit scoring algorithms are considered proprietary trade secrets not available to the general public, and (2) because every lender has its own set of lending criteria based (in part) on whatever score the lender happens to use.  Because of this opaque system, any specific prediction about a person's credit score and (more importantly) his or her future access to credit is necessarily speculative.

That said, there are certain aspects of the credit reporting and credit scoring system that are known, which we can use to make some educated guesses about how a person's access to credit will be impacted by a bankruptcy filing.

First, some basics:

Though we often refer to a person's credit score as if it's some magic number that single-handedly determines whether a person gets credit and at what rate in all circumstances, that is not really the case. There is no such thing as a universal credit score for any given person.  The term "credit score" is a generic term referring to some company's calculation of what they perceive to be a consumer's risk of default in the future.  This calculation is then sold to a lender so that the lender can make a decision about whether or not to extend credit, and at what rate.  Some lenders use their own scoring models, rather than buying a scoring algorithm "off the rack" from a third-party company.

The calculation of a credit score is based on raw data which are supposed to be predictive of a person's potential for default.  The raw data that are used are generally drawn from the information in a person's credit report from one of the three major consumer credit reporting agencies (Equifax, Experian, or TransUnion).  These companies are commonly referred to as CRAs.  Some scoring systems use additional information beyond that drawn from the CRAs, but for the purposes of this post, it is sufficient to focus on what is reported in the CRAs and for how long.

Since the raw data that are fed into the credit scoring models come from the credit reports maintained by the CRAs, it's first important to understand what derogatory payment history information makes it into the credit reports and how long it stays.

Under the federal Fair Credit Reporting Act, the CRAs are permitted to report a bankruptcy on a credit report for 10 years from the date the bankruptcy is filed.  The Fair Credit Reporting Act makes no distinction between a bankruptcy case filed under Chapter 7, 11, 12 or 13, so cases filed under those chapters are all reported for the same 10 year period.  However, the law does require the CRAs to specify which chapter of bankruptcy relief a person filed under.

This sounds like bad news for people considering a bankruptcy, but it's important to keep in mind that most other negative credit information (like delinquent payments) can and will stay on a report for 7 years.*  The 7 year period starts to run the month the first payment is missed.  The CRAs are allowed to report a delinquent debt for an extra 180 days if the account is "placed for collections" or "charged-off" more than 180 days after the delinquency.  This means that the 7-year clock can start all over again once the delinquent account goes to collections or is charged-off, but only for up to 180 days more. The upshot is that debtors have to assume that delinquencies can stay on their credit reports for 7½ years from the date they first miss a payment.

In addition, CRAs are permitted to report delinquent debts even if the statute of limitations for enforcing the debt has run and the creditor could no longer file a lawsuit to recover on the debt.  It's also worth remembering that a creditor's "charge-off" of the account does not shorten the length of time the payment delinquency is reported on a credit report.  A charge-off is merely an accounting term for when the creditor recognizes for its own bookkeeping purposes that the loan has become non-performing.

In short, the only relevant date for the purposes of calculating the reporting period is 7 years from the date of the first delinquent payment, plus up to 180 days more if and when the account goes to collections or is charged off.

All this means that, just because creditors have stopped trying to collect on a given debt (and you may have forgotten about it), it does not mean that the debt is no longer adversely impacting your credit. This is one of the many reasons why it's important to check your credit reports regularly (the other big reasons being mistakes on the credit report, which are all too common, and identity theft).

That's the background on how, and for how long, delinquent debts and bankruptcies get reported on a credit report.  Again, this is important because your credit reports provide the raw material that is used to generate a credit score, which is in turn relied upon by lenders in making credit decisions.  In my next post, I'll cover the credit score in more detail: how it is comprised in general, how much of the score is derived from payment/non-payment history, and a discussion of how bad payment history can impact the score.

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*There are a couple of wrinkles which are of no interest to anyone but me, which I include simply in the interest of completeness.  Feel free to skip.

Technically, the Fair Credit Reporting Act permits CRAs to report payment delinquencies for longer than 7 years and bankruptcies for more than 10 years if the report is to be used in in connection with certain high-dollar transactions--for example, in a credit decision expected to involve $150,000 or more.  15 U.S.C. § 1681c(b).  However, the Consumer Financial Protection Bureau reports that, as a practical matter, the CRAs "do not utilize these exemptions, and cease reporting negative information after the standard time limits have elapsed."  Consumer Financial Protection Bureau White Paper, December 2012, "Key Dimensions and Processes in the U.S. Credit Reporting System: A review of how the nation’s largest credit bureaus manage consumer data"  (Footnote 23).  Presumably this is because the burden of establishing administrative safeguards against accidentally disclosing older information in connection with non-qualifying transactions is too much for the CRAs to handle (they have enough trouble complying with the law as it is).  And in any event, it's hard to see how credit history relating to events so far into the past would be of much relevance in rendering credit decisions anyway.

Also, the Federal Trade Commission (which was the agency responsible for enforcing the FCRA until the Dodd-Frank bill shifted that responsibility to the CFPB) has issued some non-binding guidance that suggests that withdrawn or dismissed voluntary bankruptcies can be reported for ten years from the date of dismissal, rather than 10 years from the date the case is filed.  40 Years of Experience with the Fair Credit Reporting Act: An FTC Staff Report with Summary of Interpretations, Federal Trade Commission, July 2011, § 605(a)(1)(3).  This could have major ramifications for Chapter 13 debtors, where a case may get dismissed years after it is filed.  However, this FTC guidance should be ignored because it directly contravenes the FCRA (and in any event is non-binding).  The FTC guidance stems from an informal opinion letter issued in connection with an involuntary bankruptcy that misconstrues the meaning of "adjudicated" in 15 U.S.C. § 1681c(a)(1).  For a whole variety of complex statutory interpretation reasons having to do with the the terminology of the old, pre-1978 Bankruptcy Act (which was in effect when the FCRA was originally enacted in the 1970s) and the difference between voluntary and involuntary bankruptcy cases (which I will spare everyone), I believe this guidance is wrong with respect to voluntary bankruptcies and should be ignored.