Should you fear the impact of a proposal or bankruptcy on your credit rating?

Fear of the impacts of bankruptcy on the credit report is by far the biggest concern of the clients we meet. Indeed, a bankruptcy will be recorded on a credit file for 6 years (7 years for TransUnion) and a proposal, for 3 years from the moment when the proposal is fully paid. This factor can cause concerns which sometime results in delays in taking action.

So, the big question is: “Is bankruptcy or the proposal more damaging to the credit report than the status quo?”

The Federal Reserve of the State of New York published a study on this subject in 2015 to measure the impacts of significant changes to their bankruptcy law 10 years earlier. They focus was concentrated on 3 items: the credit score, access to new credit and mortgage defaults.

Their study included the financial situation of 2.5 million Americans considered to be “in a situation of delinquency on their payments” or “insolvent” for 2 years. By having access to data from their credit reports (without the ability to identify individuals in order to protect the confidentiality of the records), they were able to compare how people who opted for a proposal or bankruptcy fared compared to those who tried to cope on their own (i.e. the status quo).

A better credit report

People who filed a proposal or bankruptcy had, in the first months after the start of their bankruptcy, a lower score than others, but this situation was only temporary. In fact, after only a few months, their score exceeded that of the other people who did not file. From the moment the bankruptcy or proposal ended, they remained on average 40 to 80 points above the score of the other group (note: an “average” score is about 680). Evidently, this higher score resulted in better access to new credit. Indeed, the study shows that those who came out of bankruptcy had an acceptance rate of 15 percentage points more than those who chose not to make a proposal or bankruptcy.

Less risk of losing your home

In the United States, as in Canada, a person who goes bankrupt has the right, under certain conditions, to keep his house and his car if he or she continues to pay the mortgage or car loan. However, the study also shows that the people who were struggling with their debts but chose not to file a bankruptcy or proposal were more likely to have suffered a mortgage default and legal proceedings than the others who settled their debts through a bankruptcy or proposal. This can be explained by the fact that settling your consumer debts with a bankruptcy/proposal inevitably leaves more money to meet mortgage payments.

Conclusion

When a person is facing serious financial difficulties, a proposal or bankruptcy can be a legitimate means to quickly take control of your finances and it can even be a good (sometimes only) way to avoid losing your assets. In our experience, and the Federal Reserve study tends to confirm this, when financial problems are insurmountable, it is better to have your credit rating be affected momentarily rather than perpetuating your financial hardships and putting off the inevitable.

Reference:

Federal Reserve Bank of New York: Insolvency after the 2005 Reform, April 2015

https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr725.pdf