Southern California Bankruptcy Law Blog

Rebuilding Credit After Bankruptcy

Posted in Chapter 11, Chapter 13, Chapter 7, Home Loans

Many potential bankruptcy clients tell me that they are concerned about the possible ill effects of bankruptcy on their future credit rating.  They are surprised and pleased to learn my tips for rebuilding credit after bankruptcy.  Let me begin with a bit of background.

I.          Your Current Credit Is Poor

When someone calls a bankruptcy attorney, they’re usually behind on credit card payments, mortgage payments, or some other debt payments.  Their credit is already poor.  Moreover, with their current debt load, they will not be able to get credit or loans, except from the loan sharks.  What’s in your wallet?  Ahhh, it’s a loan shark, get it off me!

My first point:  if you’re considering bankruptcy, then bankruptcy will not harm your credit any more than it has already been harmed.  In fact . . .

II.        Bankruptcy Will Actually Improve Your Credit

One of the things I do as part of my services to each consumer client – I also do this as part of my due diligence – is order their credit report.  The report I get is an amalgamated triple report that includes entries from all three of the main reporting bureaus.  The report is tailored to bankruptcy practice, so it provides, not only the current credit score, but also the projected credit score after bankruptcy.  Almost invariably, the projected score is higher than the current score.  Why?  There are two main reasons. 

The first reason is a bit obvious:  if you’ve just discharged a lot of debt, you no longer have to make payments on that debt.  This frees up future income to make payments on future debt.

The second reason is a bit less obvious to the uninitiated, and requires a little knowledge of a few places in the Bankruptcy Code.  The gist is:  once you’ve received a bankruptcy discharge, you have to wait for years before you’re eligible to file another bankruptcy.  The time frame depends on the chapter of the Code under which the first discharge was issued, and under what chapter of the Code the second bankruptcy is filed.

My second point then is:  your credit score will probably increase because you have freed up future income for future debt, and you won’t be able to use bankruptcy to discharge that future debt for a long time.

III.       The Timing Rules

Before we get into the discussion of post-discharge credit rebuilding, and for those who care about this sort of thing, here are the timing rules:

            A.        The Second Bankruptcy Is A Chapter 7

If the second bankruptcy is filed under Chapter 7 and the first bankruptcy was discharged under either Chapter 7 or Chapter 11, then the waiting period is eight years from filing date to filing date (see 11 U.S.C. § 727(a)(8)).

If the second bankruptcy is filed under Chapter 7 and the first bankruptcy was discharged under either Chapter 12 (this is the only even-numbered chapter in the Code, and it’s designed for family farmers and commercial fishermen) or Chapter 13, then the waiting period is usually six years from filing date to filing date.  However, there are two exceptions that erase the six year waiting period:  (1) The repayment plan repaid the general unsecured creditors 100% of what they were owed, or (2) The repayment plan repaid the general unsecured creditors at least 70% of what they were owed, and the plan was proposed in good faith and was the debtor’s best efforts.  See § 727(a)(9).

            B.        The Second Bankruptcy Is A Chapter 11 Or Chapter 12    

There are no time limitations regarding a previous bankruptcy for Chapter 11 (see § 1141) or Chapter 12 (see § 1228).

            C.        The Second Bankruptcy Is A Chapter 13

If the second bankruptcy is filed under Chapter 13 and the first bankruptcy was discharged under either Chapter 7, Chapter 11, or Chapter 12, then the waiting period is four years from filing date to filing date (see § 1328(f)(1)).

If the second bankruptcy is filed under Chapter 13 and the first bankruptcy was discharged under Chapter 13, then the waiting period is two years from filing date to filing date (see § 1328(f)(2).

IV.       Post-Discharge Credit Rebuilding

When a consumer debtor receives a discharge something strange and unexpected typically happens:  they grow a third arm out of their forehead.  Whew:  I’ve got to cut back on the pre-blogging coffee.

            A.        Post-Discharge Offers

What actually happens is the debtor starts receiving offers for new credit cards, and offers to buy new cars.  We’ve already discussed the reasons:  no more debt, can’t file again for years. 

If you’re that debtor – or more precisely, former debtor – you can use these offers, together with the three things creditors care about (see section V, below), to rebuild your credit.

            B.        Avoid Unnecessary Car Purchases

I generally do not recommend purchasing a car right out of the gate, unless you really need one, because it’s one thing to carry a small debt with a high interest rate, but quite another to carry a large debt with a high interest rate.

            C.        Get Only Two Credit Cards

However, I do recommend getting a couple of the offered credit cards.  But don’t get any more than two.  Otherwise, the creditors will be afraid that you’ll cash advance and flee to Argentina. 

By the way, I mention Argentina because I once knew someone who did precisely that.  This happened in the early 1970s.  The guy, who was originally from Argentina, was a heroin addict.  The good news:  I was not a heroin addict, I just happened to know him.  Amazingly, he had a steady job working for an optometrist, and supported his habit with drug sales on the side.  I have to admit that his behavior went against the image of the back-alley addict I had at the time. 

In any event, he was arrested for possession of heroin, and knew he was going to be deported.  Since he had great credit, and quite a few credit cards, he cash advanced on all of them, and bought a car, clothes, TVs, and other consumer goods.  He then sold everything but the clothes, and fled to Argentina with a lot of cash.  The point:  if you proliferate on the cards, you’ll raise red flags with the creditors.

Back to planet earth and our previous discussion.  Get a couple of the cards and use them sparingly – this is not the kid in the candy store scenario.  Instead, it’s a way to rebuild credit.  Therefore, don’t carry balances that are higher than a few hundred (not thousand) dollars.  Initially, the interest rates will be high, and the available balances will be low.  But if you do what I’m about to describe, the rates will gradually drop and the available balances will gradually increase.  You do have to be patient.  Now for the three things creditors care about.

V.        The Three Things Creditors Care About

            A.        Creditors Want Eventual Recovery Of Principal

If a creditor lends you money, or extends credit to you (which in essence is a loan), it wants to know with a high degree of certainty that it will eventually receive its principal back in full.  Therefore, make more than the minimum payment each month.  This will reassure the creditor that it will eventually get its principal back in full.

Wait a minute:  I thought creditors made more money from people who only pay the minimum each month.  Wouldn’t they want me to just make the minimum payment?  You’re right, they do make more money on minimum payment debtors.  However, creditors identify such people as greater credit risks, so your credit score is hurt.

            B.        Creditors Want To Make A Profit

It is axiomatic that creditors are not charitable institutions.  They’re in it to make a buck.  How do they do that?  By charging you interest.  So if they aren’t going to get any interest out of you, they’re not going to be interested in you.  Therefore, do not pay off the balance each month.  This will mean that you’re paying interest, which will keep the creditor happy.

            C.        Creditors Want Predictability

Creditors want to know that the payments are going to roll on in just like clockwork every month.  Therefore, get the payments in a couple of days early each month.  This will satisfy the creditor’s need for predictability.

Another wait a minute:  I thought creditors made more money if you got the payments in a little late each month because of the late fees.  Why get them in a couple of days early?  Once again, you’re right, they do make more money on late payment debtors.  However, creditors identify such people as greater credit risks, so the credit score is hurt.

As you put into practice these three things, gradually the interest rates will drop, the available balances will increase, and your credit rating will improve.

VI.       Working Toward The New Home Purchase

            A.        The Special Bank Account

As soon as you start this process of credit rebuilding, open a new bank account.  This will be a very special bank account.  Your mind set toward it must be:  that is not my money.  You don’t use the money for groceries, housing, transportation, or anything else.  And each month you must force yourself to put money in the account.  Try to put $200 a month into the account.  It’ll be hard at first, but remember, you don’t have to make payments on the discharged debts anymore, so it should be possible.

            B.        The New Car

After twelve months, in the special bank account you have a down payment on a new car.  And you have twelve months of new credit history on those two credit cards.  Now when you trot over to the dealer you’ll get a good deal because you’ve improved your credit score and you have cash.  And let’s be blunt:  there is nothing more eloquent than cash.

            C.        The New House

For the next three or four years keep doing the credit card thing I described above, and get the car payments in a couple of days early each month.  And keep depositing money in that special bank account each month.  Force yourself to do it. 

At the end of the three or four years you’re ready to buy a home.  You’ll have several years of good credit card and car payment history, and you’ll have a down payment in that special account.

VII.      Epilogue

The key virtue you’ll have to develop for all of this to work is patience.  Rebuilding credit takes time and discipline.  But if you stick with it you will eventually have what you want.  And it will be possible because you’ve gotten rid of your current debts through bankruptcy.  See?  It’s not so bad.

You may feel that once is enough.  You never want to have credit or debt ever again.  If that’s your position, then more power to you.  I don’t want to dissuade you from that if that’s your goal. 

However, if you think you’ll want to buy a house or car in the future, and don’t think you’ll be able to pay cash, then my thoughts should help you achieve those goals.  Good luck.