Chances are you’ve never heard of a bankruptcy score, but you should add it to your financial vocabulary because it may be impacting your ability to secure a mortgage or any other kind of credit more than you know.
Like most people, your credit score is the first thing you think of when you consider getting a loan or credit, but your credit score is only one part of the overall story that lenders look at to asses how risky you might be.
Credit scores have a bit of a delay built into them. They only reflect the past, and what lenders really want to know is the future. Which is why they have developed another system that you won’t find on your credit report.
Your bankruptcy score is a projection of your potential financial future.
It takes into account certain indicators of your overall credit riskiness and aims to predict whether or not you are likely to declare bankruptcy or go into a consumer proposal in the near future.
Both Equifax and TransUnion have their own proprietary algorithms that purport to uncover financial red flags that are not so obvious on the first glance of the credit report.
How bankruptcy scores work
Credit scores only tell one part of your overall story, particular the past and present. They are useful, but they may not be very accurate in predicting future behaviour. And that is where the bankruptcy score comes in.
Sometimes, there can be a significant lag between when a borrower reaches the point of no return and when that reality will reflect on their credit score. You can have an otherwise solid credit score in the 600-700 range and be just on the verge of defaulting on your payments. This is what the bankruptcy score tries to predict.
It turns out there is a significant difference in behaviour between someone with bad credit that will eventually declare bankruptcy and someone with the same score who won’t.
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One of the key indicators of the former type of behaviour is using one type of credit to pay another type of credit. This is a good sign that the borrower is overstretched and may be on the edge of not being able to make their payments on time. But because the payments are still being made on time, the credit score for this hypothetical individual hasn’t caught up yet.
What your bankruptcy score means to you
Compared to someone with a bad credit score who will stay afloat, someone who is at high risk of going bankrupt tends to:
- Use credit more often
- Apply for credit more often and have more recently acquired debts or credit accounts
- Have fewer accounts in collection. (This is because people who rely on debt to pay more debt are often careful about not missing payments in the belief that this will grant them access to more credit);
- Have a higher credit utilization rate, for example carrying a credit balance that takes up a large percentage of your borrowing limit.
If you don’t want your bankruptcy score to prevent you from securing a house or credit card, all you have to do is avoid these kinds of activities. Simply put, don’t act like someone who is living beyond their means and their ability to pay.
If you are using one credit card to pay off another, get off that hamster wheel and start making payments to your debts with your money, not borrowed money.
Perhaps the most important recommendation is one that will impact your credit score as well.
Carrying a high balance on your credit accounts is a double hit to your ability to borrow. Not only do lenders look at that as risky behaviour that indicates you may default in the future, it also actively suppresses your credit score each month your balance is above 50% of your total limit.
By reducing your overall debt load, not only will you save money on interest payments each month, you will appear less risky to lenders and your cost of borrowing money in the future will go down.
Action steps for today:
- Take stock of where you are right now. Get a clear understanding of the amounts of money you owe, what your monthly payments are, and how much you are paying in interest.
- Calculate your monthly income.
- Put together a budget that you can stick to. There are a number of resources available online to help you do this in addition to apps like Mint that make it easy.
- Your budget should include money set aside specifically for paying down your debts. Make those payments regularly, put them on a calendar, set a reminder on your phone. Do whatever it takes to make sure you make those payments otherwise you will fall into the same habits that got you there in the first place.
- If you are disciplined enough, put your income directly onto your credit cards and use those cards to pay for your expenses. As long as the income is greater than the outgoing payments, you will make progress on your debts and not have to worry about missing the monthly payments.
The key takeaway here is, don’t act like someone who is going to go bankrupt!