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Bankruptcy Reform: The Impact on Consumer Credit Reports

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What Is the Bankruptcy Reform Act?

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 essentially mandates that if your income is greater than the state median income, you must go through additional screening — the means test — to determine whether you can file for Chapter 7 bankruptcy and wipe out most, or all, of your debts, or pay back some of your debt with a Chapter 13 repayment plan of up to five years. Here’s a closer look at each type of bankruptcy.

What Is Chapter 7 Bankruptcy?

A Chapter 7 bankruptcy essentially dissolves all debts that legally qualify for dissolution. It’s safe to say that many, if not all, debts incurred prior to filing a Chapter 7 are discharged. A discharge, when referred to in the context of bankruptcy, is when all personal debt liability is erased. In other words, the consumer is no longer required to pay off unpaid credit accounts.

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    What Is Chapter 13 Bankruptcy?

    A Chapter 13 bankruptcy is different from a Chapter 7 in that the consumer must pay off some or all of his debts over time. This option, mostly reserved for consumers who have a steady income, allows creditors to recover a portion of the money they are owed. Unfortunately, a significant percentage of the consumers who originally file a Chapter 13 are unable to continue to make their payments and eventually convert to a Chapter 7.

    How the Bankruptcy Bill May Affect Credit Reports and Credit Scores

    As part of the new law, consumers are required to receive credit counseling from an approved nonprofit credit counseling agency. This counseling must occur within 180 days prior to filing for bankruptcy. The counseling that consumers will receive is not a Debt Management Plan (commonly referred to as a DMP), which is the core competency of credit counseling agencies. Instead, this counseling is designed to help consumers learn about alternatives to bankruptcy and how to improve their credit management skills. As such, this counseling has no direct impact on consumers’ credit reports or credit scores.

    If the consumer does decide to pay back their debts rather than file for bankruptcy and enters into a Debt Management Plan with an approved credit counseling agency, this action will eventually show up on a consumer’s three credit reports. This is still not likely to have an impact on the consumer’s credit score. (You can view two of your credit scores for free on Credit.com.)

    Several years ago, FICO, the company that created credit scoring, made a significant change to their credit scoring models. They reprogrammed the models so that enrolling in a DMP would not hurt a consumer’s credit scores in any way. The decision to do this was very much in the consumer’s favor. At one time, enrolling in a debt management plan had the same negative impact on credit scores as filing for bankruptcy. The change in the credit scoring models was fortuitous with respect to the credit counseling requirement of the bankruptcy bill. Today, consumers are not harmed by attending counseling sessions or by signing up for a Debt Management Plan.

    How Long Can a Bankruptcy Stay on a Credit Report?

    A Chapter 7 bankruptcy will remain on your credit files for no longer than 10 years from the date it was filed. The accounts that are discharged as part of the bankruptcy will be removed no later than seven years after their activity ceases. Therefore, any negative information about the accounts included in Chapter 7 bankruptcy will be long gone by the time the bankruptcy filing is removed.

    A Chapter 13 bankruptcy will remain on your credit file no longer than seven years from the date it was filed, or no longer than 10 years from the date filed if it has not been discharged, or completed. As with Chapter 7 bankruptcies, the accounts that are discharged as part of the bankruptcy will be removed no later than seven years after their activity ceases.

    Consumers who wish to file for Chapter 7 now need to prove they are eligible. This test will be based largely on a complex formula that determines your eligibility for Chapter 7 protection. Any of your creditors can dispute your request for Chapter 7 and can move the request be denied in lieu of a five-year repayment plan under a Chapter 13 bankruptcy. Your income must be less than your state’s median income, or you will have a harder time qualifying for a Chapter 7.

    The obvious impact on credit reports is that more consumers will have to file for Chapter 13 rather than Chapter 7. As such, your creditors will continue to receive a partial payment from you each month, as opposed to nothing at all.

    This article has been updated. It was originally published Oct. 30, 2013.

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