Wait for bankruptcy discharge before applying for credit

Opening Credits columnist Eric Sandberg
Erica Sandberg is a prominent personal finance authority and author of "Expecting Money: The Essential Financial Plan for New and Growing Families." She writes "Opening Credits," a weekly reader Q&A column about issues for people who are new to credit, for CreditCards.com.

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Question Dear Opening Credits,
In two months, I will have a Chapter 13 bankruptcy discharged. I would like to apply right now for a PayPal line of credit. Will that red flag me, being that I have two months left before a bankruptcy discharge? -- Sharon


Dear Sharon,
How exciting that you’re so close to the finish line! Should you jump the gun and apply for credit before completing the race to a positive net worth? I advise against it. Here’s why, along with some background on the subject.

A Chapter 13 bankruptcy is a court-approved, trustee-supervised payment plan that lasts up to five years. While it’s in effect, you send a predetermined portion of your income to your creditors. At the end, some debts (such as property taxes and past-due child support) will be fully satisfied, while others (such as collection accounts and credit card balances) may only be partially paid – if at all.

Upon completion of the payment portion of the bankruptcy and passing a financial management course, you’ll receive a discharge that formally forgives you of the remaining balances. Don’t worry about the course, though. It’s simple and is designed to give you the information you need to avoid making borrowing and budgetary mistakes in the future.

In the meantime, you’re still using the Chapter 13, and the creditors you’ve included expect to be paid as much as possible out of your earnings. Taking on a new financial obligation can cut into what they receive. For this reason you’ll need to get the court’s permission first, and the trustees that are monitoring the bankruptcy might turn you down. However, there are some circumstances where you may be granted permission. For example, you may need a reliable new car to get to work so you can pay your creditors, and so will approve the loan.

Even if the trustees allow you to open a line of credit, though, getting approved is another story. Not only is the bankruptcy notification appearing on your credit report (a Chapter 13 is listed for seven years from  the filing date), you’re still sending payments. That means a significant portion of your income is already dedicated to debt.

A credit issuer, whether it’s PayPal, a bank or a credit card company, will analyze your credit history as well as your current financial capability to determine if you’re a good customer. Reducing debt and making steady payments is great and is showing up on your credit reports, but some lenders will still perceive the fact that you filed for bankruptcy as a warning sign. And until the Chapter 13 is complete, you have less cash to work with, so the lender may question whether you can really afford another payment.

If you apply now, you run a higher risk of being rejected than you will when you’re no longer making those big payments. Then you’ll have an unnecessary hard inquiry on your report that can pull your scores down even further, which is exactly what you don’t want.

Wait out the 60 remaining days. About a month after the bankruptcy is finalized, check your credit scores. With that information you can pursue the type of credit product that best matches your rating. The PayPal line of credit may be fine, but review other available options before deciding. You may want start with a secured card instead. You can use it anywhere, and the cash deposit you need to open the card reduces lending risk, making them easier to qualify for than unsecured accounts.

Just be sure to mind the lessons you learned in that financial management course: Charge only what you can and will repay within 30 days. Your scores will climb, but your debt won’t. Soon you’ll be able to save the money that you’ve been sending to your creditors. Use it to fund emergency and retirement accounts – and at least a little fun. Chapter 13 bankruptcies can be quite restrictive and completing one is an achievement. Congratulations!

See related: Chapter 13 bankruptcy: How it works

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Updated: 10-21-2018