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When you file for bankruptcy, you should know that this negative mark will stay on your credit report for 7-10 years and its immediate impact will be a 100-200 point drop in your credit score.
OUCH!
Yes, that hurts but the reason you choose bankruptcy is to get a “second chance” managing your finances and that second chance includes steps to rebuild your financial future and credit score.
The first one, says attorney David Chami, managing partner of Consumer Attorneys, would be to make sure bankruptcy is the best way out. A call to a nonprofit credit counseling agency will help you determine if there is another debt-relief option that will solve your problem.
“Use this service (nonprofit credit counseling) to actually see if bankruptcy is necessary,” Chami said.
Think of bankruptcy as a tradeoff. It wipes away or reduces debt you can’t pay, but it also identifies you as a credit risk and makes getting a credit card, a personal bank loan or a mortgage difficult in the near term and can impact your credit long term.
“Most people who are considering bankruptcy are already struggling with debt and therefore their credit is already in the toilet, so bankruptcy will actually serve to help fix their credit,” Chami said.
For those with good credit who consider filing bankruptcy due to a medical emergency, business failure, divorce or death of a primary wage earner, credit score damage is more substantial. They are the ones who could be facing a 150-200 point wallop to their credit score.
Even though filing bankruptcy remains on your credit report for 7-10 years, it doesn’t impact your ability to obtain credit that entire time as long as you can pay your bills on time. For example, the timeline for chapter 7 bankruptcy is a matter of months, and many people get credit cards shortly after discharge. You can even potentially get a car loan after filing a bankruptcy (although probably at a very high interest rate).
“The discharged debtor must remain current on all regular obligations that survived the bankruptcy,” said George Vogl, managing director of Stretto, a bankruptcy technology and services firm. “This usually includes mortgage payments, car payments, and other secured debts where the debtor agreed to keep the secured property in exchange for keeping their obligation on the debt.”
A nonprofit credit counselor can help you plan a strategy if you feel uncertain about what to do. If you follow a strict budget, pay your bills on time and use a secured credit card, the credit rating agencies can elevate your credit score to a solid level within two years.
What Is Bankruptcy?
Bankruptcy is a legal process offering a fresh start for people and businesses unable to pay their debts.
The most common bankruptcy options for individuals under water financially are liquidating assets to pay their debts (Chapter 7) or creating a repayment plan (Chapter 13), typically over a period of 3-5 years. The latter is often called “wage earners bankruptcy.”
Filing bankruptcy can provide consumer protections and give people a chance to get their debt under control by working with credit counseling agencies, bankruptcy attorneys and financial planners.
“Bankruptcy protection is part of the U.S. federal code for a reason,” Vogl said. “It is often the best option for the honest but unfortunate debtor who finds themselves in severe financial trouble. Most consumer bankruptcies are triggered by an event such as an unexpected medical emergency or job loss. Bankruptcy is often the only option that is going to allow the person to return to a stable financial place.
“Bankruptcy is also an extremely powerful process, with the ability to stop foreclosures, repossessions, wage garnishments, collection lawsuits and much more. It is not the right solution for every financial issue, nor should it be, but it is an extremely effective process when warranted.”
Immediate Impact of Bankruptcy on Credit
If you know your score before filing for bankruptcy, get ready to watch it plunge. Filing for bankruptcy immediately affects your credit score. How significant the impact is a matter of what score you brought into the bankruptcy filing process.
A person with an average 680 score would lose between 130 and 150 points in bankruptcy. Someone with an above-average 780 score would lose between 200 and 240 points. In the end, both people would be tagged as risky borrowers, making it difficult or impossible to get loans or unsecured credit.
Keep in mind that depending on the type of bankruptcy, you might not be able to borrow money without court approval. In the early stages of bankruptcy, and in some cases throughout the process, the financial restrictions you’ll face would make it extremely difficult to get a car loan or mortgage until after your bankruptcy is discharged.
Long-Term Effects of Bankruptcy on Credit
One of the cons of filing chapter 7 bankruptcy is that it will negatively affect your FICO score for 10 years. A Chapter 13 filing, because it involves partial repayment, remains on your record for seven years after receiving a Chapter 13 discharge or dismissal.
Bankruptcy’s impact on your credit score will also vary according to how much debt was discharged and the ratio of positive to negative accounts on your credit report. This is because major credit score factors such as late payments and credit card utilization will be reset.
New credit is not impossible with the flashing red light of bankruptcy on your credit report, but you’ll be challenged to obtain new credit, at least new credit that doesn’t come attached to a punitive interest rate.
Before filing you should educate yourself on the long-term consequences of bankruptcy. Consulting with a credit counseling agency or bankruptcy attorney before you file can eliminate the last thing you need in such a stressful situation – a surprise complication.
Bankruptcy filings and the damage they do to credit scores can have a long-term impact on insurance rates, housing applications and employment opportunities. Vogl points out another consequence individuals should know.
“Borrowers will often find that lenders who were included and discharged in their bankruptcy will absolutely refuse to work with them,” he said. “Thankfully, there are plenty of lenders on the market.”
Beyond the obvious consequences of bankruptcy – credit rating damage, loss of property, higher interest rates when securing new credit, smaller pool of creditors – bankruptcy attorneys point to how the social stigma of filing for bankruptcy can affect individuals’ sense of self-worth.
For some that damage lasts as long as it takes to rebuild their credit rating.
Rebuilding Credit After Bankruptcy
Though you can’t do anything about the amount of time bankruptcy remains on your credit report, you can take steps to speed up the rate at which your score recovers.
First, don’t fall for a pitch from a credit repair company that offers to restore your credit rating for a fee. It can’t be done. Those are scams. The only way to rebuild credit is to become a paragon of financial responsibility.
Here are some steps to help you rebuild:
- When you receive a legitimate bill for anything, pay it before the due date. If you have an account dating back prior to a bankruptcy filing (a home mortgage, for instance), make sure you never fall behind on a payment. If you filed Chapter 13, always make court-ordered payments to creditors on time.
- Open a secured credit card. Credit card issuers will give you a secured card if you deposit cash that covers the credit limit. If you want a credit card with a $1,000 spending limit, you’ll send $1,000 to the card issuers as a security deposit. Though this might seem strange at first, it offers the convenience of paying with plastic and, if you make payments when they’re due, your credit score will improve.
- Monitor your credit score monthly using CreditKarma or Chase Credit Journey, two websites that provide scores. If you use credit responsibly and pay bills on time, your score gradually will rise. Eventually, you will be able to obtain an unsecured credit card, which you should do when the opportunity is available.
- Don’t go overboard. One secured credit card is all you need early in post-bankruptcy. Simply using the secured card and then paying the monthly statement in full will begin rebuilding your credit. If you had trouble managing money in the past, the disciplined use of a single card will not just rebuild your credit score, it might even help you build new and better spending habits.
- When your credit score begins improving, plan a spending strategy. If you qualify for a no-fee credit card, choose it rather than one that charges an annual fee. Make a budget and stick to it so you never again accrue debts that you’re unable to pay monthly. If an emergency forces you to run over budget and run balances on your credit cards, aggressively pay off the card debt as soon as the emergency passes. Try to build an emergency fund so you don’t need to run credit card balances in the first place.
- If you have student loans, keep paying them. Student loans rarely are discharged through bankruptcy but paying them on time signals to the credit-rating bureaus that you are managing your debt responsibly, and that will help revitalize your credit score. (Note: On November 17, 2022. The Department of Justice issued much anticipated new guidance on discharging student loans in an attempt to lessen draconian standards for student loan relief through bankruptcy. “Since the guidance was issued, we’ve seen successful discharge of student loans in over 70% of cases where it has been pursued,” Vogl said. “Taken in conjunction with the (Biden) administration’s efforts to forgive student loan debt, it is now very realistic that an individual who qualifies for bankruptcy protection will have a reasonable chance of discharging their student loan debt as well as their other debts.”
- Consider a credit-builder loan if you need money and can repay the loans. Community banks and credit unions most commonly offer these loans at affordable interest rates. If you borrow $500 or $1,000 and pay it off on schedule, it will become part of your credit report and will help improve your score.
Misconceptions About Bankruptcy and Credit
It’s easy to feel overwhelmed at the prospect of filing bankruptcy even while recognizing it as a necessary step that can lead you out of the financial wilderness. It’s much harder to separate fact from fiction about the consequences bankruptcy invites.
Counter to one claim people in financial trouble often hear, bankruptcy does not ruin your credit forever. You can get credit again.
“The best thing you can do to restore your credit score is to show the world that you can make on-time payments on new credit,” Chami said. “Many creditors are eager to give small credit lines to consumers coming out of bankruptcy.
“The companies will generally charge higher interest rates but if you keep really low balances on the card (under 15% of the available credit limit) and make your payments on time you can restore your credit score into the 700s in 12-24 months.”
Vogl agrees. Responsible fiscal management over time can lead to a full recovery.
“No less than six months after the bankruptcy discharge, the debtor should seek to open a new line of credit and use it responsibly,” Vogl said. “Finally, time will heal the debtor’s credit. The further back the bankruptcy discharge is on the calendar, the more the individual’s credit will recover.”
Alternatives to Bankruptcy
As Chami suggests, a consultation with a nonprofit credit counseling agency – even before contacting a bankruptcy attorney – can help individuals explore their options and provide better peace of mind about whether or not to file bankruptcy.
Options include the following strategies:
- Negotiating with creditors. Know that you must strictly adhere to the new terms negotiated.
- Paying off debt with a second job or through gig work.
- A loan from family or friends. Warning: put any agreement in writing to spare misunderstandings or resentments that might crop up.
- Debt management plans (DMP). With a debt management plan through a nonprofit credit counseling agency, you can reduce the interest rate owed on credit card debt to 6% (or less) and pay off your debt in 3-5 years.
- Debt consolidation loan. All unsecured debt is paid with one loan. But debt consolidation loans require individuals to have good credit. If you’re considering bankruptcy, that might not be you.
- Debt settlement. A deal where your debt is settled for less than what you owe. Beware sketchy debt settlement companies and know that in many cases you can reach a debt settlement without them.
The Road to Financial Recovery
The saying about how it’s darkest before the dawn came from a travelog written centuries ago (long before neon lights flashing “Payday Loans” from street corners.)
But it could certainly apply to any individual taking the first step toward financial recovery.
While bankruptcy has serious consequences, it can be a pathway to a fresh start. Ask for guidance from a nonprofit credit counseling agency or bankruptcy attorney. Filing for Chapter 7 or Chapter 13 could be your best option.
Educating yourself about available options can be overwhelming while dodging what might well feel like a financial avalanche. But think of it as the storm before the calm.
