Lessening the Impact of Bankruptcy on Your Credit
June 18, 2001, Revised November 22, 2004, Reviewed February 4, 2011

To the genie who generates credit scores, all bankruptcies (and all foreclosures) have the same statistically-determined impact on credit scores. The genie never asks why a borrower went into bankruptcy or foreclosure.

Some lenders, however, like to go behind the scenes of credit scores to assess why they are what they are. The premise is that the more you know of the circumstances underlying a particular credit score, the better able you are to assess how good a risk a credit applicant is looking ahead. The lender mentioned in this letter does this.

"My husband has been out of a Chapter 13 bankruptcy for a year. In applying for a loan, the loan officer said that they needed letters of explanation for the bankruptcy and late payments that appear on our credit report. I don’t understand -- what is the lender looking for in the letters of explanation?"

Ask yourself, if you were being asked to lend money to someone who had just come out of bankruptcy, what would you like to know about the bankruptcy?

If you were rational, and most lenders are, you would like to know the likelihood that you will enter bankruptcy again. The story you tell the lender will influence the lender’s judgment about that.

If the bankruptcy was caused by outright recklessness, the lender will assume that the probability that it will happen again is high, unless you convince him otherwise. If you are no longer the reckless person you were, how or why have you changed? Have you had a religious conversion? Joined AA? Entered psychoanalysis? In explaining why reckless behavior will not be repeated, the burden of proof is on you.

Lenders would much rather hear that the bankruptcy was caused by unforeseeable misfortunes that were beyond your control. The burden is still on you, however, to persuade the lender that the misfortune is very unlikely to recur.

For example, the firm for which you worked for 15 years suddenly and without warning went out of business. If you now have a new position, you can make a case that this is unlikely to happen to you again. A bankruptcy caused by a natural catastrophe or serious health problem is similar, provided that you are persuasive in arguing that they were one-time events.

Be prepared to back up your story with documents or verifiable details.
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