How Does Bankruptcy Affect Interest Rates on Loans?
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Credit Reports
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When a debtor gets in over her head and can no longer afford to repay outstanding financial obligations, she may be forced to consider filing bankruptcy. Designed as a method for overburdened borrowers to escape repayment obligations, bankruptcy allows debtors to legally wipe away debts they can't pay and begin a new financial life with little or no debt. Although the legal process is intended to give borrowers a "fresh start," the bankruptcy filing is reported to major credit reporting bureaus, where it is recorded on the borrower's personal credit history for seven to 10 years (depending on the chapter of bankruptcy code used during the filing process). This alerts future lenders that the borrower incurred large amounts of debt and used legal methods to escape repayment, a fact that may make the borrower a high-risk investment for financial institutions.
Interest Rates Reflect Risk
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When a lender issues a loan to a borrower, a number of factors influence the borrower's interest rate. Among the most prominent factors is the amount of risk the borrower represents to the lender. Institutions who lend to low-risk customers may be reasonably assured that their investment will be repaid, so the interest rate may be lower than for a riskier customer. If a borrower seems unlikely to repay the loan, the financial institution may elect to charge a higher interest rate so that the borrower will repay a larger amount early in the loan life, reducing the lender's loss if the full amount cannot be repaid.
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Bankrupt Borrowers are Risky
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In the eyes of a lender, a borrower who has previously filed bankruptcy has developed a record of incurring debt that he is unable to repay, so the lender considers that customer a significantly higher risk than other borrowers. As a result, the lender issues credit at a markedly higher interest rates in an effort to minimize losses should the borrower default or file bankruptcy again.
Symptom of Other Problems
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Many lenders use automated credit scoring systems to evaluate the risk level associated with each potential borrower. When a debtor files bankruptcy, her overall credit score is lowered. Most borrowers who file bankruptcy do so only after falling behind or defaulting on a number of debts, though, so the credit score may be severely damaged before the bankruptcy process even begins. For this reason, it's possible that bankruptcy might have little or no effect on interest rates for debts incurred shortly after the bankruptcy discharge.
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