I had the pleasure the other day of reading an article on a website called nerdwallet.com called “When Bankruptcy is the Best Option”. It raised a number of issues that I would like to take the opportunity to expound upon. It also cited two of my favorite Federal Reserve articles, one published by the Federal Reserve Bank of New York and the other by researchers at the Philadelphia Federal Reserve Bank.
One concern that people commonly have when filing bankruptcy is what impact it will have upon their credit score. This article cites some findings from the researchers at the Federal Reserve Bank in Philadelphia. The article quotes the following findings:
- “The average credit score for someone who filed Chapter 7, the most common type of bankruptcy, in 2010 was 538.2 on Equifax’s 280 to 850 range. (Scores in the low 600s and below are generally considered poor.) By the time the filers’ cases were discharged, usually within six months, their average score was 620.3.”
- “The other type of bankruptcy, Chapter 13, requires a three- to five-year repayment plan, which most people don’t complete. (Half of Chapter 13s filed between 2007 and 2013 were dismissed, and an additional 12 percent were converted to Chapter 7s or other types of bankruptcy, according to an American Bankruptcy Institute analysis of Justice Department figures.) Those who did and got a discharge, though, saw their [credit] scores rise from 535.2 to 610.8, the Philadelphia Fed researchers found.”
These findings indicate two important points that I have often made to clients. The first and most important is that it is much easier to rebuild credit out of bankruptcy than it is to rebuild credit out of a mess. Generally speaking, by the time somebody comes to see me about filing bankruptcy, their credit is already shattered and their credit scores are declining, not increasing. What is more, there is no reasonable prospect of them getting their financial house in order on their own and thus improving their credit score. While the Philadelphia Federal Reserve Bank is referring to what happens to credit scores six months after discharge, it is also important to note that those scores are rising and not falling. As such, a credit score that is poor at the time of filing and fair six months after discharge can reasonably be expected to be good a year or two after discharge, assuming that the person otherwise has their financial affairs in order. The article quotes an economist who co-authored the New York Federal Reserve Bank study who stated that “within a year you are way better off” and also said “it is a pretty rapid rate of recovery”.
I am particularly fond of that New York Federal Reserve Bank study in part because it came from the New York Fed. It is hard to think of an institution that is closer to the Wall Street Banks than the New York Fed. As such, I would expect no one to be more hostile to the filing of bankruptcy and more laudatory of the bankruptcy reform of ten years or so ago than the New York Fed. However, the New York Fed published this article which clearly established that people who file for bankruptcy protection are far better off in terms of their credit and finances than similarly situated people who do not file. The study was also highly critical of the reform and indicated that its primary result was to force more people out of bankruptcy and into long term insolvency and to transfer significant wealth from the insolvent to the banks. However, more important than the political aside, is that even researchers at the New York Fed are recognizing that if the concern is credit and rebuilding your financial life, bankruptcy is a much better choice than any other alternative.
The Nerd Wallet article actually turns the issue of credit on its head by writing up a section titled “Savings Your Credit Score is Only One Reason” for why a person may want to file for bankruptcy protection. I particularly enjoyed their heading “An End to Collection Hell”. Over the years I have referred to it as “Saving Your Sanity”. The article discusses the fact that once you fall behind everything only gets worse, not better. Delinquencies become defaults, defaults become accelerations, accelerations become judgments, judgments become supplementary process, liens and garnishments and all along the way all kinds of extra fees and costs and penalties are being tacked on so that the debt is growing dramatically. What the article does not elude to is the fact that the telephone is ringing off the hook with harassing phone calls; court dates start happening, deputy sheriffs and constables start showing up at the house with court summons and threats of arrest. The whole system is designed so that you can never get out of this mess, and to drive you absolutely insane with the process. The article then goes on to point out some of the types of debts that bankruptcy can liberate you from. It then returns to the issue of credit. Here it goes back to the New York Fed author who points out that people who fall one hundred twenty days or more behind on some or all of their payments are more likely eighteen months later to have new credit lines if they filed bankruptcy than if they have not. Once again, he is eluding to the fact that not only do you see the immediate jump in credit score from poor to fair that the Philadelphia Fed points out in the immediate term, but over time those scores continue to rise into the good, and even into the very good, range. Those people who avoid bankruptcy filing, often out of fear of what impact it will have on their credit, wind up with poor credit even several years later.
Finally, the article discusses the role of bankruptcy attorneys. I was obviously pleased to see the heading “You Need A Bankruptcy Attorney”, and totally agree with that. The article notes that the paperwork is complicated and it is easy to make mistakes. Errors can cause your case to be dismissed, and if that happens you not only end up with no bankruptcy relief and thus with all of the problems that people who did not file bankruptcy have, but also the hit to your credit score that does come from filing bankruptcy. Those folks get the worst of both worlds. Understand that I am not saying, and this article is not saying, that bankruptcy does not go on your credit report, and does not have a negative impact. What we are saying is that there are two different credit reports a person in financial distress might have. One is a credit report that is full of delinquencies, collection matters and unpaid debt, but no bankruptcy. The other is a credit report that has a bankruptcy on it, but has had all of the other credit problems erased. As between those two credit reports, the person whose credit report has a bankruptcy, but is otherwise pristine, is in a far better place than a person whose credit report is a mess, but has no bankruptcy. Both of those people are better off than somebody who has filed for bankruptcy, but because of their own errors did not get a discharge.
The article does discuss the issue that attorneys “want to be paid up front” and how that can be an issue for a lot of people. I have my own solution to that problem which has worked very well over the years. The need to be paid up front is absolute. Bankruptcy lawyers are unsecured creditors whose fees are discharged as part of the bankruptcy. As such, any lawyer who does not insist upon being paid up front, at least in the Chapter 7 context, clearly does not know very much about bankruptcy, and should be avoided. However, I have been doing bankruptcy work for well over a quarter century and know full well that people in financial distress have a hard time coming up with money. This is why I am extremely flexible, and often creative, about attorney payment plans. In fact, I am so flexible, we have no actual plans. It is more a matter of what can the client afford to pay and when can they pay it. My only rules are that I like the first payment to be at least $200.00, because at that point I become responsible for you; your creditors start contacting us; we start taking paperwork and getting down to business, so I need to know that you committing. My other rule is that I will not file until I am paid in full. I am unconcerned how we get from that $200.00 payment to the final payment. In the meantime, we have come up with a number of creative ways of doing this. Perhaps my favorite for clients who come in during the Fall, Winter and sometimes even the late Summer is that I will do their taxes for them for free and then when they get their refund they can pay me off. We will take payments weekly, monthly, sporadically, it really does not matter. I prefer that a payment plan not last more than a year, but they often times do.
The last section of the article says “Don’t Wait Too Long”. One of the most tragic things that I see is that people throw good money after bad in an effort to avoid filing for bankruptcy. I cannot tell you how many people have drained their 401(k)s or other retirement plans in an effort to pay debt that they then wound up filing bankruptcy to discharge. This is tragic on both sides. 401(k)s and other retirement plans are generally exempt assets. The trustee in bankruptcy cannot touch a 401(k) under all but the most bizarre circumstances. As such, debtors are taking an exempt asset that they could have kept in bankruptcy and giving that money away. That they paid some of their debt before filing does not help them in any way. Frankly, from my point of view, there is no difference between a client who is $70,000.00 in debt and has $50,000.00 in their 401(k) and a client who has $20,000.00 in debt and paid off $50,000.00 of debt with their 401(k) that they no longer have. In fact, the latter case is likely to cause problems, especially if some of that $50,000.00 was to pay back friends and family. There is no problem with discharging friends and family in bankruptcy and after the bankruptcy is over taking money from the 401(k) to pay them off. Although raiding retirement money is the most common thing that we see, I have also had clients sell cars or put second mortgages on their houses unnecessarily, again to pay down debt that they ultimately end up discharging in bankruptcy anyway. I wholeheartedly agree with the columnist’s statement that “we advise debtors in over their heads to investigate bankruptcy first”. For most people who cannot pay their bills, bankruptcy really is the best option.