25 Sep 2009

Obtaining Credit After Bankruptcy, is Chapter 7 or Chapter 13 Better?

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Many clients worry about obtaining loans or an extension of credit after bankruptcy.  Most clients are under the impression that Chapter 13 is “better” and that creditors will look more favorably upon them after a bankruptcy if they filed under Chapter 13 instead of Chapter 7.  Many know that Chapter 13 involves repaying at least a portion of total debt through a payment plan.  Truthfully, I doubt whether this factors into a creditor’s decision to extend credit to someone after a bankruptcy.  

Clients also ask which type of filing is “better” for their credit score after bankruptcy. The truth is there are many factors that play into determining a credit score and the exact formula used to determine a credit score is probably only known by a select few (the following website appears to contain some good information on what factors are used to determine your credit score: http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx)

I usually advise clients not to be concerned about the effect of Chapter 7 versus a Chapter 13 on their credit scores. Indeed, a filing under Chapter 7 or Chapter 13 can stay on a credit report up to 10 years from the date of filing. That said, if I had to chose, I would say Chapter 7 is “better.”

Consider this, a typical Chapter 7 proceeding lasts approximately 4-5 months from the date of filing to the date of discharge. Once a Chapter 7 client receives a discharge, he/she can immediately begin to rebuild their credit. Nothing in the Bankruptcy Code prohibits you from immediately applying for credit after a discharge. If new credit is used responsibly, a client’s credit score should improve.

It’s also worth noting that client’s credit reports usually have months and sometimes years of derogatory marks and are filled with negative information. Most of this information is deleted after the client receives a discharge, so their score has nowhere to go but up. A higher credit score after bankruptcy may also be realized by reaffirming certain debts in a Chapter 7. If the debtor reaffirms a debt (continues to pay an otherwise dischargeable debt as previously agreed or on modified terms) such as a vehicle, the creditor will likely continue to report information relating to that debt to the credit bureaus. If paid as agreed, this should serve to improve a credit score.

Now, let’s examine Chapter 13. Chapter 13 payment plans last a minimum of 3 years (unless 100% of the debt can be paid in less time), and up to a maximum of 5 years. Chapter 13 clients are not permitted to incur new debt while making payments under their plan without first obtaining permission from the court. Thus, clients are not able to create new, positive remarks on a credit report or have old, derogatory remarks removed, until they receive a discharge. A Chapter 13 client does not receive a discharge until they successfully complete their plan or the court awards a hardship discharge prior to the completion of the plan (very rare). Thus, Chapter 7 affords the client opportunity to rebuild his/her credit sooner than the Chapter 13 client.

So, if you were to take two individuals, both with the same credit history, put one in a Chapter 7 and the other in a Chapter 13, which one do you think will have a better score after 5 years? Probably, the Chapter 7 client.