One thing debtors are concerned about is their credit scores and the impact filing bankruptcy might have on them. Indeed, as the economy continues to struggle, the importance of credit scores has grown. Although they are not the be-all and end-all of one’s creditworthiness, banks, landlords, insurers, and even potential employers often use them to assess a borrower’s, tenant’s, insured’s, and worker’s trustworthiness. Thus, the Internet is filled with articles about ways to improve your credit score. It can help to know the components of the score and how it’s calculated.
The credit score was created by the Minneapolis, Minnesota-based Fair, Isaac, and Company, named after its founders Bill Fair and Earl Isaac. (“Fairness” has nothing to with it.) From the corporation’s name we get its commonly used acronym, FICO. Although it was founded in 1956, the first FICO scores didn’t appear until 1989. The score ranges from 300 to 850, but the most common scores tend to be on the low end.
The formula for calculating the FICO score is supposedly a proprietary formula, but it’s mostly been figured out. The score contains five components.
(1) Payment history (35 percent)
On-time payments maintain good scores and improve poor ones. Late payments reduce FICO scores, though the less paid, and the later the payment is, the quicker the score will drop. Because payment history plays such a large role in the FICO score, it’s usually better to file bankruptcy than miss payments.
(2) Credit capacity used (30 percent)
If a bank offers you $15,000 in credit for a credit card, then the more you charge on the card, the higher the credit capacity you are using. High capacity usage tends to reduce scores; low usage increases them. This can lead to unusual situations that reduce or raise one’s credit score. For example, increasing the credit limit on a credit card will improve a credit score, but closing an account will reduce a score.
(3) Length of credit history (15 percent)
The longer one’s credit history is, the higher one’s credit score will be. The only caveat is in rare situations when someone becomes debt free for a long period of time. In that case their credit score will actually drop, the reasoning being that the person hasn’t “proven” that he or she is creditworthy.
(4) Types of credit used (10 percent)
FICO scores reward debtors who take on different types of credit, e.g. credit card debt, mortgage debt, etc.
(5) Past credit applications or searches (10 percent)
The FICO score algorithm tries to punish people who apply for numerous lines of credit (called “hard inquiries”). It also tries to separate potential borrowers who are just rate shopping with different lenders. The penalty usually disappears a year after the inquiries occurred, though they appear on credit reports for two years. “Soft inquiries,” such as those made by employers, or by consumers for their own use, don’t cause a score reduction.
Filing bankruptcy often improves credit scores because it consolidates late payments and high debt accounts into a new “included in [chapter 7 or chapter 13] bankruptcy” category. At that point, debtors’ situations are compared not to those who have high debts and late payments, but to other people who have filed bankruptcy. People in this situation tend to be more creditworthy than people who don’t file at all.
As always, the three major credit bureaus, Equifax, Experian, and TransUnion allow consumers one free credit report per year. Also, avoid obtaining free reports from Web sites like freecreditreport.com because they are often not really free.
For answers to more questions about credit card debt, bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced Bankruptcy Law Changes Bruce Weiner for a free initial consultation.