One of the most common questions a New York bankruptcy lawyer hears is: How does bankruptcy affect credit scores? The best response is that credit scores are trivial compared to debtors’ financial problems. Bankruptcy is about accepting sunk costs of bad debt, even if it’s triggered by unfair circumstances such as a job loss or a divorce. It’s also well known that filing bankruptcy can improve credit scores. In fact, a recent post on the Federal Reserve Bank of New York’s Liberty Street Economics blog investigates how the “bankruptcy flag” on consumers’ credit scores affects lenders’ subsequent behavior. It adds details to the answer debtors seek on the topic.
The author of the NY Fed post raised the question by noting a few observations about the bankruptcy flag based on federal law and the Fed’s Consumer Credit Panel. One, the bankruptcy flag stays on credit reports for a fixed interval of time after consumer bankruptcies, ten years for a “successful” chapter 7 case and seven years for a successful chapter 13 filing. The author defined bankruptcies as “successful” if it reaches discharge in either chapter. A bankruptcy is “unsuccessful” if the bankruptcy court dismisses the debtor’s case or the debtor does not complete all the chapter 13 plan payments. According to the author’s estimates, four-fifths of bankruptcies are filed in chapter 7, of which nearly all are successful, and the rest are filed in chapter 13 with a success rate over 50 percent.
The data show that the credit bureaus remove bankruptcy flags on time for roughly 70 percent of successful chapter 7 debtors and 80 percent for successful chapter 13 debtors. For the remaining debtors, it appears the bureaus remove the flag early. For unsuccessful chapter 13 debtors, the flag is removed after ten years for 60 percent of debtors with many seeing it removed earlier.
The author showcased several findings about bankruptcy debtors. One, whether their bankruptcies succeeded or not, debtors’ credit scores usually fell by about one hundred points in the four years before filing. Two, their credit scores rebounded after bankruptcy. The author attributed this phenomenon to debtors redirecting income dedicated to discharged debts toward debts that were not discharged–and the fact that debtors cannot file bankruptcy again for a number of years depending on the chapter, eight years for chapter 7 debtors and four years for chapter 13 debtors. For the unsuccessful chapter 13 debtors, the author speculated that lenders write-off some of the debts as unpayable if not discharged.
Three, the removal of the bankruptcy flag alters lenders’ behavior quite significantly. In the years leading up to the flag’s removal, debtors’ credit scores improve back to their initial levels four years before the filings. However, once the flag is removed, successful debtors’ scores instantly jump by about ten points. Although, there is a bump for unsuccessful debtors as well.
Four, when the flag is removed, credit-card limits for successful debtors begins rising noticeably, but there is no clear jump as with credit scores. The author interpreted this shift as evidence of increased credit access for debtors thanks to the bureaus’ removal of the bankruptcy flag.
The NY Fed’s blog post is here.
The evidence is clear that removing the bankruptcy flag does affect how lenders treat debtors. More subtly, the post shows how debtors’ start experiencing problems with their creditworthiness before bankruptcy and that it improves after bankruptcy. It’s one more reason to worry less about credit scores than how to resolve financial difficulties.
If a credit bureau has kept a bankruptcy flag on your report for longer than the legally allowed limit, you can read about removing a bankruptcy filing from a credit report. If you are experiencing debt problems, then talking to an experienced New York bankruptcy lawyer can help you explore your options.
For answers to more questions about bankruptcy, the automatic stay, effective strategies for dealing with foreclosure, and protecting your assets in bankruptcy please feel free to contact experienced Brooklyn bankruptcy attorney Bruce Weiner for a free initial consultation.
