What Does Bankruptcy Do to Your Credit?
“Bankruptcy” is a terrifying word for many Americans.
You always hear the stories about Hollywood stars that went bankrupt, or recent divorcees that lost all their money to their greedy ex-spouse. Bankruptcy often carries a sad tone, as if it’s the classic redemption story: everything taken away, only to build yourself back up again.
Talking about bankruptcy is almost taboo, but it helps thousands of people every year. What exactly is bankruptcy, and how does it affect your credit score? Is filing for bankruptcy really giving up, or can it be a chance for a new start?
What is Bankruptcy?
There are four different versions of bankruptcy: Chapter 7, Chapter 11, Chapter 12, and Chapter 13. Only Chapter 7 and 13 can affect individuals and are the most common, and the other two are mainly for large organizations or businesses that need to close their doors to pay off debts (or get bailed out).
NOLO.com, a DIY legal advice website, breaks down the difference between Chapter 7 and 13:
- Chapter 7 is for low-income debtors that are looking to dissolve their unsecured debts (such as credit cards of medical bills). Sometimes these debtors will have property that they can sell to pay back what they owe, but that is not always the case. Either way, it helps the person in debt start from fresh.
- Chapter 13 is also known as reorganization bankruptcy. In Chapter 13, the debtor makes enough money that they qualify for repayment plans to help pay back their debts over a three to five year period. There are some perks with Chapter 13 that Chapter 7 doesn’t offer; one of which is keeping your property. NOLO clarifies: “Typically, Chapter 13 bankruptcy is for debtors who can afford to make monthly payments to get caught up on missed mortgage or car payments or pay off nondischargeable debts such as alimony or child support arrears.”
According to Gambrell and Associates, PLLC, Chapter 11 is for larger corporations, but individuals can also file under Chapter 11 if the 7 or 13 option doesn’t provide the relief they need. Normally the cut off for Chapter 11 is over a million in joint assets for married couples.
Chapter 12 was made specifically for farmers or fishermen and payments are made on a seasonal basis to account for income. The cut off for filing for Chapter 12 is even higher than Chapter 11, to account for assets: somewhere between one to four million dollars total.
Once you file for bankruptcy, there’s no turning back. Chapter 7 and 11 filings will follow you for ten years, and Chapter 13 for seven year on your credit report, and can often get in the way of new credit or loan opportunities, and some job opportunities. However, having the ability to start fresh without debt can be a welcoming change for those that need the extra help.
How Does it Affect a Credit Score?
Generally speaking, filing for bankruptcy is the worst thing you can do to your credit. However, when diving into specifics, the answer is a bit complicated as it all depends on your history of credit, according to MyFICO.
If you start out with strong credit, say in the 750 to 850 range, then filing will cause your score to plummet. On average, the drop is close to 200 points.
However, if you have poor credit already, due to delinquent payments or a high debt-to-asset ratio, then your credit score might drop only a couple of points. Some publications have even reported a slight upward bump in the credit score of certain individuals, simply because their credit score was that bad.
Chapter 7 and 13 bankruptcy will both affect your score equally, but some creditors, when looking at your report, might favor one over the other. Since Chapter 13 sets up repayment options, creditors might see this as a sign of responsibility, but that is not a guarantee.
Although filing for bankruptcy is sure to hurt your credit score, there are some sure-fire ways to rehabilitate it within a few years time. By adding “positive” credit history to your score, you can see an increase within a four or five year period. This can be done with secured credit cards or installment loans, and by making regular payments on all existing debt post-bankruptcy. As long as you keep your debts low, but your payments up, you can recover your credit score over time.
What’s the Benefit of Filing?
NOLO does a great job of breaking down the benefits of filing for bankruptcy. Even if it doesn’t help your score immediately, it might set you up for a faster score recovery. They state:
“If you are already behind on debt payments, continue to fall further behind, or have accounts in collection, bankruptcy can help get you back on your feet sooner than other types of debt management programs. That’s because bankruptcy gets rid of many types of debts and provides you with a fresh financial start. When you reduce your debt load and get your finances under control, you can start making loan and credit payments on time, reduce your debt-to-income ratio, and take other steps to rebuild your credit. If you don’t file for bankruptcy and continue to limp along — making late payments, defaulting on debts, and increasing the amount of debt you have compared to your income — you’ll never be able to improve your credit.”
Although bankruptcy is an extreme option for debt rehabilitation, it could be a safe “last resort” for many people in extreme debt. When paired with other forms of debt rehabilitation – such as secured credit cards or debt consolidation – it can help many people recover from massive debt at a much faster rate. Within four to five years you could see a higher score on your report if you work proactively to stay out of debt.
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Katie McBeth is a researcher and writer out of Boise, ID, with experience in marketing for small businesses and management. Her favorite subject of study is millennials, and she has been featured on Fortune Magazine and the Quiet Revolution. She researches SEO strategies during the day, and freelances at night. You can follow her writing adventures on Instagram or Twitter: @ktmcbeth
This post was updated August 8, 2017. It was originally published March 21, 2017.