After Bankruptcy

August 6, 2017
 
 

After Bankruptcy

Borrowers often ask their attorney what their lives will be like when they emerge from bankruptcy. The answer is that they will be free from a crushing debt load. But many people fear that it cannot be that simple, that they will be stigmatized and penalized for declaring bankruptcy. That is untrue, as we shall see.

 

Damage to Reputation?

The question of whether bankruptcy will damage a borrower’s reputation or her access to credit has no definite answer; but there is much evidence that society is lenient toward such people.

Bankruptcy is a right under the law, and the Constitution provides for it. A person’s bankruptcy is a matter of public record, but newspapers rarely report it. The result is that bankruptcy’s damage to reputation is usually imperceptible, not the public stigma that people fear. Large corporations like Chrysler, General Motors, KMart, Macy’s, and United Airlines have declared bankruptcy, but have won back the trust of customers, shareholders, and banks. Many famous people have declared personal bankruptcy or had a business go bankrupt, only to become successful or continue with their careers. Donald Trump, Walt Disney, actor Nicholas Cage, singers Willie Nelson and Michael Jackson, and President Abraham Lincoln all fall in that category.

Even the Bible provides respite from debt after seven years:

At the end of every seven years thou shalt make a release. And this is the manner of the release: every creditor shall release that which he has lent unto his neighbor and his brother; because the Lord’s release hath been proclaimed. (Deut. 15:1―2)

The one place where a bankruptcy can be a stigma is in a small town. A local vendor whom many people know may not get paid due to a customer’s bankruptcy, and that can mobilize the insular community against the customer. A borrower may be able to avoid that outcome by paying off the local creditor’s debt before she files for bankruptcy; however, the bankruptcy trustee will have the right to set aside the preferential payment (see next section).

 
 

Access to Credit

Similarly, bankruptcy damages a borrower’s access to credit far less than people imagine. A bankruptcy stays on a borrower’s credit score for up to ten years, but whether a person emerging from bankruptcy can obtain credit depends on the individual lender. Someone with numerous unpaid debts already has poor credit, so bankruptcy’s freeing such a person from debt will be viewed positively by some lenders. Also, someone who has filed chap. 7 bankruptcy is ineligible for another bankruptcy for six or eight years, and that protects a lender. Some lenders actively solicit recent bankrupt debtors for just that reason.

Another factor that facilitates post-bankruptcy access to credit is that lenders’ credit standards have loosened in recent years. Indeed, a debtor is sometimes offered a credit card while she is in bankruptcy, albeit one with a high interest rate. Most lenders do not automatically exclude a borrower with a recent bankruptcy from consideration. Rather, each lender has its own formula for determining creditworthiness, based on income, assets, credit history, employment history, etc. Current income probably counts for more with most lenders than does credit history. And a 1971 study found that even back then, credit was scarcer after bankruptcy for only a third of those surveyed.

Mortgage lenders often follow Fannie Mae’s underwriting guidelines. They require a lender to wait, before making a loan, four years after a chap. 7 bankruptcy, four years after a dismissed chap. 13 bankruptcy, and two years after a completed chap. 13 bankruptcy. But today, ten years after the Great Recession started, mortgage lenders are again soliciting subprime borrowers.

In short, a person who emerges from bankruptcy can often gain access to credit.

 

Potential Pitfalls

One arrangement that can be a trap for a debtor is a reaffirmation agreement. The way it works is that a debtor who is emerging from bankruptcy receives an offer of credit from one of her former creditors, with the terms’ including a reaffirmation agreement. That lets the borrower to get a credit card, but at a price: she must reaffirm some of her previous debt that was discharged in bankruptcy, and the old debt is added to the new card’s balance. Such an agreement can help a person after bankruptcy by providing access to credit; but the borrower should accept it only if she fully understands the debt burden that she will assume.

Predatory lending can also be a pitfall. Used-car dealers, mortgage brokers, and other facilitators promise to “work with” an individual with a recent bankruptcy. But the interest on a “bad credit” used-car loan or home mortgage is so much higher than a normal rate, that it can create new financial problems for the borrower.

Rent-to-own schemes providing furniture or an expensive television set are subject to the same criticism, so are tax-refund anticipation loans. The credit that they offer is expensive, particularly if it is available to a borrower with a recent bankruptcy.

 

Two Ways That a Person Can Obtain Credit After Bankruptcy

(a) Paying off a creditor shortly before or shortly after bankruptcy

Before declaring bankruptcy, a borrower can completely pay off one of her credit cards that has a small balance. The creditor, in return, will probably allow the borrower to use her credit line after bankruptcy, or even during it. The bankruptcy trustee may set aside such a payment as a preference for one creditor over another; but the trustee may not do so, and in any case such a preferential payment is not illegal.

To avoid a payment’s being set aside as a preference, a borrower can pay off a creditor after bankruptcy, even if the debt has been discharged in her bankruptcy. In return, the lender agrees to extend credit to the borrower notwithstanding her recent bankruptcy. (See Pitfalls, below.)

(b) Obtaining a secured credit card

A borrower can rebuild her credit standing after bankruptcy by obtaining a secured credit card. With such a card the borrower posts a bank deposit as collateral, and the amount of credit that she receives is determined by the amount of the deposit.

That may not sound like credit; but it lets a borrower create a new credit history. If she makes her payments on time, the lender will, at some point, almost certainly extend additional credit to the borrower that is unsecured, while still requiring collateral for the credit line’s secured portion. Eventually, if the borrower keeps making timely payments collateral should become unnecessary, so that the borrower is again trusted with completely unsecured credit.

A secured credit card can thus allow a decisive borrower to start rehabilitating her credit score immediately after bankruptcy, instead of just passively waiting one or two years till she becomes eligible for credit again.

 

Avoiding Financial Trouble

A necessary ingredient of any borrower’s plan to stay out of financial trouble after bankruptcy is for her to have sufficient income. With that said, the next essential ingredient is the borrower’s being sensible about spending money. A person emerging from bankruptcy should only buy things that she really needs. And if a product or service does seem necessary, a person can take these precautions:

  • she should shop around for a good price;
  • compare credit terms before accepting an offer;
  • read and understand a loan’s paperwork; and
  • get credit counseling if she becomes overextended.
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    (a) Accepting credit

    Credit should be utilized with care after bankruptcy. Even if a borrower’s financial position has improved enough for her to be offered credit, that does not necessarily mean that she should accept it. Instead, she may:

    1. decline a credit card until she is ready to make the payments and use it responsibly;
    2. not accept multiple credit cards just because they are available;
    3. know what a card’s fees are, as well as how much its interest rate is;
    4. beware of low teaser rates that soon increase;
    5. determine how much the card’s late-payment charges and penalties are; and
    6. read the disclosures and contract accompanying a credit-card offer.

     

    (b) Using a credit card:

    If a recent bankrupt does get a credit card, using it wisely will be one way to stay out of financial trouble. It will help if she:

    1. sticks to a realistic budget;
    2. resists the temptation to cover budget shortfalls with the credit card;
    3. does not use the card to dig herself out of financial trouble;
    4. makes more than the minimum payment;
    5. doesn’t run up a large balance;
    6. pays on time; and
    7. ignores special offers that put subscriptions or products on the card.

     

    Conclusion

    Bankruptcy is less likely to damage reputation and access to credit than most people realize. But a borrower must be careful to spend money and utilize credit more conscientiously after bankruptcy than she did before it. It as easy as that; and as difficult.

    Attorney Katz can be reached at (800) 251-3529