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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.


* 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.