Rebuilding clients’ finances after bankruptcy

Often, when you’ve focused on solving a client’s debt problems, it’s difficult to think about what has to be done next. Even basic advice on working toward good credit can help a client re-establish his finances faster than he would on his own.

How bankruptcy appears on a credit report

Lenders use credit reports to predict future activity. When a person completes a bankruptcy or consumer proposal, his debts and the history associated with those debts are removed from his credit report. Instead, a notation appears in the report’s legal section describing when he filed for bankruptcy (or a consumer proposal) and when it was completed. This notation remains on his report for up to six years from your client’s date of discharge, or three years from the completion of a consumer proposal.

The different timelines often prompt the question, “Which is better for credit renewal, a bankruptcy or consumer proposal?” Well, a typical bankruptcy runs either 9 or 21 months and the note remains on your client’s credit report for 6 additional years. Most consumer proposals run for 4 to 5 years and the note remains for 3 additional years. If they sound about the same in terms of credit repair, that’s because they are. There’s not enough of a difference in so far as credit reporting goes to recommend one procedure over the other. Choosing between the two as a debt recovery tool is more a matter of the client’s financial situation than the impact on their credit report.

As to credit repair after any form of insolvency, it is how your client conducts their financial affairs after filing either bankruptcy or a consumer proposal that really matters.

Bankruptcy doesn’t deal with secured debts (such as mortgages, car loans and leases), so if your client has any of these debts, they’ll remain on his credit report. It’s common following a bankruptcy that the only items still appearing as active debts are a person’s mortgage and car loan. These will go a long way toward re-establishing credit, but won’t do the whole job.

Rebuilding credit

Once a client has filed for bankruptcy, he can start rebuilding his credit.

Lenders are looking for at least $5,000 in new credit, secured or otherwise, following a bankruptcy. This usually takes the form of a secured credit card or line of credit. Secured cards look and act like standard credit cards, but their credit limits are secured against funds held on deposit. The savings earn interest and will be released after a couple of years. If for any reason your client fails to make a required payment or defaults on the credit card, the money on deposit is seized. A secured line of credit is similar.

Once your client obtains either a secured card or line of credit, he needs to actively use the account; otherwise, there’s no history to list on his credit report. Your client should deliberately charge items to the credit card and then pay it off. This demonstrates the use of credit as a tool, rather than a necessity. It sounds like a trick, but in reality, your client is using credit the way it is intended to be used: as a replacement for cash, not a replacement for longer-term borrowing.

If your client obtains and uses his new credit properly, he’ll find his credit report and score have improved dramatically after two years. The two-year period is the minimum history that most reputable lenders will consider with a loan application.

Clients should also limit the term of any new borrowing in the first couple of years following discharge from bankruptcy. For example, it’s possible to be approved for a mortgage two years following a discharge, but such clients usually have to pay an interest premium.

The lender will probably encourage your client to agree to a five-year term, explaining to your client that they are a credit risk and it’s safest. While your client may be a credit risk in year one, every month their credit rating will improve such that by year two it is unlikely they will still be considered high risk. Locking in for five years simply means your client will be subjected to higher interest for a longer period of time (and therefore make the lender a lot more money).

The truth is, your client should agree to a one- or two-year term at most. If he doesn’t have any issues paying during the term, when he renews he should qualify for going market rates. The difference may be as much as two full percentage points, which over the life of a mortgage can add up to tens of thousands of dollars in reduced interest charges.

So bankruptcy or a consumer proposal does not automatically negate the ability of anyone to obtain credit within a short period after completing either procedure. With better credit and money management after bankruptcy, anyone can rebuild a credit rating within a couple of years and be eligible.

Ted Michalos

Tax & Estate

Ted Michalos , B.A., CPA, is a Licensed Insolvency Trustee and co-founder of Hoyes, Michalos & Associates Inc. in Ontario, Canada.