There's a catch-22 in credit: It's easiest to get it when you already have it. Informed consumers who want to get back on their feet after bankruptcy can do so by applying for a secured credit card offer from a leading issuer, kicking off a process of rebuilding their credit score by having their monthly on-time payments reported to the credit bureaus.
Why credit cards are a first step
Logically, the best time to lend money to someone may be immediately following a bankruptcy. With their debts forgiven or restructured, most people exit bankruptcy in their best financial shape in years. But not all lenders are keen to look at it this way, as many are reluctant to lend to people who have recently exited bankruptcy.
Credit cards offer the best way for people to get started rebuilding a solid credit profile after bankruptcy for two reasons:
- Cards are a small risk. A credit limit of $500 or $1,000 on a credit card is relative small potatoes compared to an auto loan or mortgage. Thus, most banks feel pretty comfortable about making credit cards more accessible to people just out of bankruptcy than other types of credit.
- They report to the credit bureaus like any other loan. Credit card companies report your activity to the credit bureaus just as they would any other type of credit. As a result, a credit card offers a free way to start building up good data points on your credit reports after bankruptcy.
Starting small with credit cards
A Chapter 13 bankruptcy will fall off your credit report seven years after the filing date, whereas a Chapter 7 bankruptcy will disappear after 10 years. That's a long time to wait.
Building up a post-bankruptcy credit profile is important because it stands as a record that you have changed your habits and are carefully managing your budget in the present time. If you don't have any new records after bankruptcy, lenders won't have any indication of how you're managing your finances now, which could set you back if you need to borrow in the future.
A smart way to start rebuilding your credit is by opening a secured credit card account. Secured credit cards differ from traditional unsecured credit cards in that they require a deposit (collateral) to open an account. For example, two of the best secured cards on the market require a deposit of $49 to $200, depending on your creditworthiness. That deposit opens the door to a secured card with a credit limit of at least $200.
Secured credit cards are a great way to get back on your feet because they can be issued to just about anyone. The deposit eliminates much of the risk for the bank. Thus, anyone, even people with recent bankruptcies, can qualify for a secured card. In addition, secured cards report to all three major credit bureaus just like any other credit card.
That said, you need to make payments on a secured card as if it were an ordinary unsecured credit card. Failing to make payments on time will cost you in fees and hurt your score when payments are more than 30 days late. The deposit you make to open a secured credit card account is meant to be a payment method of last resort if you cannot repay your balances, not as a prepayment for your future spending.
The post-bankruptcy playbook
A bankruptcy shouldn't preclude you from being able to borrow money on good terms in the future. But to get back in lenders' good graces, it's important that you follow some simple rules that will help you improve your credit report and credit score so that you can put your best foot forward when that time comes.
Here's how to get back on your feet, step by step.
- Open a credit card account. A secured card is likely your best bet because it is almost certain that you will be approved. The key thing here is to avoid secured cards with annual or monthly fees, which are unfortunately very commonly marketed to people who have a recent bankruptcy. We at Fool.com have curated a short list of secured cards that report to all three credit bureaus and do not charge any monthly or annual fees. By all means, shop around, but whatever you do, don't sign up for a card that carries any type of fee just for having an account. It's completely unnecessary to pay fees to get a secured card.
- Use your new card once per month. After getting approved for your new card, you should use it sparingly. I suggest using it just once per month for a tank of gas or for paying a small recurring bill like a Netflix subscription. Using the card at least once a month ensures the account will remain open. Using it for a small purchase ensures that you never use more than 30% of your credit limit, since having a balance higher than 30% of your credit limit can hurt your already fragile credit score. (On a card with a $200 credit limit, keep your balance below $60 at all times for the best results.)
- Pay it off in full each month. Every month, you'll receive a statement detailing your purchases and your balance. To avoid paying any interest on the balance, make sure that you always pay the "statement balance" by the due date. If you avoid cards with annual or monthly fees and pay the statement balance in full each month, you'll be on the path toward rebuilding your credit without paying a penny in interest or fees.
- After six to 12 months of on-time payments, check to see if your card can "graduate" to an unsecured card. Credit card companies can turn your secured card into an unsecured card by mailing you a check for your deposit. So, after a year of on-time payments, it's possible that your secured card with a $200 credit limit may turn into a $1,000 unsecured credit card, for example. Reach out to your card company to ask if your card can graduate after you have made several on-time payments. Don't be afraid to ask more than once, but after a year or so, you may want to open an unsecured card if your card won't graduate to an unsecured card.
- If graduation is unavailable to you after a year, consider opening another credit card. The best cards at this point in time will likely be balance transfer credit cards, which are designed for people who have imperfect credit histories. The reason for opening another credit card account is to get a credit card that can have its credit limit increased over time. Having a higher credit limit that you use responsibly can help you further improve your credit score after bankruptcy. If your secured card can graduate to an unsecured card, then this step is unnecessary.
- Ask for credit limit increases with regularity. Most card companies allow you to ask for a credit limit increase on your account every six or 12 months. Increasing your credit limits (but not your spending!) will help you show your lenders that you're capable of using higher limits responsibly. I think you would agree that someone who always has a low balance on a card with a $20,000 limit has proven their ability to use credit responsibly more so than someone who has a low balance on a $1,000 card.
If you follow the steps above, one by one, you'll quickly begin to rebuild your credit and show potential creditors that you can manage your accounts responsibly. In as little as one year, you can see huge improvements in your credit score as your bankruptcy becomes less important compared to the good history you built up more recently.
Of course, the most important thing you can do is get started sooner rather than later. You never know when you might need a good credit score to finance a major purchase like a home or car, but by working to improve your credit now, you'll be sure that you can put your best foot forward when that time comes.