One of the first things you’ll discover when you have a bankruptcy on your credit report is lenders get wary. Make no mistake, they see that entry that reads Chapter 7 or Chapter 13 bankruptcy, and the red flags go up.
From their perspective, this is completely reasonable. After all, they don’t know why you declared bankruptcy, they just know that you did. Human nature being what it is, some of us tend to assume the worse. And one of the most important aspects of being a loan officer – the person who decides whether to extend credit to or not – is the ability to identify smart risk as opposed to bad risk.
With a bankruptcy entry sticking out of your loan application like a sore thumb, it’s no wonder loan officers many times turn down people with a bankruptcy.
That’s where a bankruptcy letter of explanation comes in: it explains in short, simple language the events that led to your current financial situation, how you’ve already started repairing your credit, and how you’ll pay back the loan you’re applying for. It can be useful not just in appealing to the good nature of whoever is looking over your application, it can have a very concrete, numbers-based impact on whether your application is approved or declined.
The Ingredients of a Good Bankruptcy Letter of Explanation
A good place to start with a letter of explanation for your bankruptcy is to define what it is not: it’s not a lengthy confession detailing a history of your spending, not a line-by-line audit of your credit history, and definitely not a long, drawn-out plea for mercy. In the grand scheme of things, this letter will only be one item among all the others in your loan applications, but it is the most human.
And if you know what to say to a lender and how to explain your financial situation honestly, it can easily be one of the most impactful and important pieces.
Three key things to include in every letter of explanation:
- The reason you declared bankruptcy.
- The steps you’ve taken to repair your credit.
- Your plan to pay back the loan you’re applying for.
1. Why You Went Bankrupt
Bank employees and loan officers have seen it all when it comes to personal finance. So while conducting business with a bankruptcy hanging over the proceedings may seem novel to you, it will not be for them. Banks live in the real world, too, and they are managed much like a business. They know financial misfortune can strike everyone, even the most vigilant and thrifty spender.
This letter is your opportunity to lay out the specifics of your case. If it was a medical situation that gutted your bank account, be honest. Without going into any sensitive specifics (besides protecting your own privacy, there are laws regarding the protection of personal health information and banks will not want to hear every detail), it’s important to be clear. Was it an insurance problem? Did a misdiagnosis lead you to spend money on treatment for something you never had?
Again, the loan officer is going to do their job, but they’re also humans. Chances are they or someone close to them has experienced financial hardship due to a medical emergency. It’s a sad statistic, but the fact is hundreds of thousands of Americans declare bankruptcy each year due to medical bills. If that’s you, rest assured you’re not even close to being alone.
Or if much of your personal wealth is tied to the stock market (if you’re an investor, for example, a day-trader, etc.), even the slightest ripple in the stock market can have a huge impact on your bank account. Banks learned this lesson in 2008, so a clear (yet brief) explanation of your investments and financial strategies will go a long way in their decision.
In this first section, also include any debts the bankruptcy did not wipe out, such as student loans, alimony and child support, and certain unpaid taxes. The idea is to give the bank or lender as much clear information about your financial situation as possible.
They don’t necessarily know better than you when it comes to handling money but remember that you are the one going to them and asking for a loan. The least you can do is be upfront and honest (and expect the same in return, of course).
Never try to hide a prior financial obligation in your letter of explanation but be sure to explain how you have those expenses covered and are ready to take on the new loan you’re applying for.
2. What You’ve Done to Repair Your Credit
This is the section where you get to show off your hard work. You’ve already gotten through the bad news and now you can show the bank or lender how you have taken steps to right the ship. Hopefully, you began the process of repairing your credit after bankruptcy as soon as possible.
Granted, a loan officer isn’t going to expect any big revelations here. They understand that as someone with a bankruptcy on your credit report, your credit options are limited at the moment. But anything you’ve done since you’ve filed for bankruptcy – and really, anything – to show that you’ve become more financially responsible will be a big plus in your column (even if the bankruptcy wasn’t your direct fault, as mentioned above).
Rebuilding your credit could include things as small as getting a credit card after bankruptcy and making your monthly payments on time. Or it could be as big as the house you and your dad just cosigned on. It’s important not to inflate anything in your letter of explanation, but don’t leave anything out just because your name isn’t in the paperwork either.
For instance, if you’ve agreed to set aside $100 a month for your niece’s college fund and you’ve remained committed to putting that $100 aside every month and consider it just another bill, explain that to the bank. You’re human and believe it or not, there are humans in those big banks, too.
Common steps to rebuild your credit include:
- Applying for a secured credit card
- Cosigning a deed
- Monitoring your credit reports regularly
One of the easiest and fastest ways to repair your credit after bankruptcy is to apply for a secured credit card. These cards are designed specifically for people with bad credit. They usually require a down payment of under $1000, which then becomes your spending limit.
You’re essentially borrowing your own money from the bank which you then pay back (with interest; although depending on the card, it’s possible they’ll refund all interest if you’ve kept current with all payments). This not only keeps the bank safe (in their eyes), it also gives you very reasonable parameters to spend within and it will be harder to overextend yourself.
Monitoring your credit and showing a fluency in your credit reports means you are fully interested in your finances. Banks, of course, love this from the people they’re loaning money to. It demonstrates responsibility, and far too often banks see bankruptcies occur simply due to fiscal irresponsibility. If that isn’t you, make sure they know that.
And make sure you explain that you realize the gravity of your financial situation (your credit is bad, but it’s not the end of the world) and your part in that. Everyone, including lenders, love to see someone learn and grow from their mistakes. It’s in our nature to help those who are helping themselves. Get that across in your letter of explanation and you’re golden.
3. Your Plan to Pay Them Back
Let’s face it: on the surface (at least in the eyes of almost all lenders), you’re a bad bet. You have a bankruptcy on your credit report, after all, and the loan officer has a dozen more applications to review before the end of the day. You’ve explained why you declared bankruptcy; you’ve assured them that your finances are stable. If you’re already managing debt like a secured credit card, so much the better.
But that still may not be enough to persuade whoever is reviewing your application. What can and oftentimes does seal the deal is a comprehensive plan on how you will return their money.
By this point in your letter, you should have already laid out your current income and monthly bills. You’re aware of your credit score and you review your credit reports thoroughly (if you’ve hired a credit repair company, mention that). Now comes the part where you factor in the new loan you’re applying for.
Come up with a simple line budget showing money coming in and money going out and where the monthly payments for this new loan will come from (if you haven’t already you must create a budget after bankruptcy). The simpler you can keep it, the better. All they want to see is enough room in your budget to comfortably absorb the extra payments.
When to Include a Letter of Explanation for Bankruptcy
Include a letter of explanation every time you’re putting together a loan application, even if it is not required or mentioned by the lending institution (of course, if it’s specifically stipulated that a letter of recommendation cannot be included, do not include one). As long as your letter of explanation is written in plain English and your points are made clearly and succinctly, it can only help your case as to why you deserve to be a trusted borrower.
Again, honesty is key here because if the bank comes to find out you withheld information that would have changed their decision – even if you did nothing illegal per se – the chances that they will want to do business with you again are extremely low. By being anything but transparent in your letter of explanation, you’re effectively burning a bridge. And that’s the last thing you want to do when you’re rebuilding after bankruptcy.
Making It Count
Tailor each letter to the specific lender you’re applying to. Thinking of it like a cover letter for a resume isn’t too off in this regard. It’s not your life story, but it’s not exactly a letter of introduction. What it should do is introduce the reason you had to declare bankruptcy in the first place, what you’ve done to repair your credit since then, and your current plans to pay back the money you want to borrow.
And you may have noticed that the reason why you want the loan should not be included. There are a few reasons, but, in short, even though you may have the most virtuous reasons for wanting the money, the bank or lender is not going to be too interested. Plain and simple.
Whether you’re planning to use the money to build a free school in a Third World country or if you need it for a new car loan after bankruptcy, it makes little difference to them. They just want to make sure you can pay them back.
A good letter of recommendation can do all this and more. It can provide the bank with answers to questions they have before they even need to be asked. More than anything, it shows that you’ve done your homework, you’re taking your finances very seriously, and you’re responsible. And that’s all lenders want to see from somebody rebuilding after a bankruptcy, a sense of responsibility.