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Filing bankruptcy is an action you can take if you're unable to manage your debt. While it might be the right decision for your financial situation, filing for bankruptcy is one of the worst things you can do for your credit.
Declaring bankruptcy reflects poorly on your ability to handle debt and is likely to affect how future lenders view you as a potential borrower. If you're considering filing bankruptcy, here's what you need to understand before you take that step.
How Does Filing Bankruptcy Work?
For individuals, bankruptcy is a legal proceeding involving a borrower and their creditors. The process will have you formally declare that you cannot meet your debt obligations and can allow you to obtain relief from some or all of your current debts. Bankruptcy should be considered only as a last resort after you've exhausted all other options, including debt consolidation and a debt management plan (more on that later).
Bankruptcy is complex, so you'll want to hire an attorney to help you through the process. Depending on your situation, you may file one of two types of bankruptcy: Chapter 7 or Chapter 13.
Chapter 7 Bankruptcy
This form of bankruptcy provides borrowers with a clean slate, so to speak. A court trustee will supervise the sale of certain assets—some may be exempt, such as cars and basic household furnishings—and give the proceeds to your lenders.
The remainder of what you owe will be eliminated upon discharge of the bankruptcy, which is a legal order releasing you from the debts covered under the proceeding. In other words, you'll no longer be obligated to make payments.
Since Chapter 7 bankruptcy wipes out your debt, it may seem like an appealing option. But you'll need to undergo a means test to determine whether you're eligible, and you can lose important assets if you choose this route.
Chapter 13 Bankruptcy
Instead of providing a clean slate like Chapter 7, a Chapter 13 bankruptcy can reorganize your debts in a way to make them more affordable. You'll typically get on a three- or five-year plan, during which you'll repay some or all of what you owe.
Once you've completed the repayment plan, your bankruptcy will be discharged. While this option may not be as appealing to some, it may be a good idea in the long run if you can manage it.
What Happens to Your Credit When You File for Bankruptcy?
Your payment history is the most important factor in determining your credit score, and filing bankruptcy means that you won't be paying covered debts in full as you initially agreed.
As a result, filing bankruptcy can have a severely negative impact on your credit score. A Chapter 7 bankruptcy will remain on your credit reports and affect your credit scores for 10 years from the filing date; a Chapter 13 bankruptcy will affect your credit reports and scores for seven years.
Regardless of which type of bankruptcy you choose, lenders will be able to see it on your credit reports in the public records section and it's likely to be a factor in their decision-making. Once you've completed the legal process, it will show that both the bankruptcy and the debts included in it have been discharged.
If you apply for credit, lenders may not approve your application unless the bankruptcy has been discharged. Even then, you may have a hard time getting approved for certain types of loans. If you do get approved, you may face steep interest rates and other unfavorable terms.
How to Rebuild Credit After a Bankruptcy
While a bankruptcy will remain on your credit report for seven or 10 years, that doesn't mean your credit score can't improve during that time. As you add new positive information to your credit report, you can rebuild your credit score.
Here are a few things you can do to make it happen:
- Monitor your credit. It's crucial that you check your credit score and credit report frequently. Not only does this help you keep track of your progress, but it also provides you with the information you need to address potential issues that could further damage your credit score.
- Pay your bills on time. Make it a goal to pay all bills on time going forward to avoid late payments. Remember, your payment history is the most influential credit score component, so it's a top priority.
- Stick to a budget. It's important to avoid debt that could potentially destroy all the work you've done so far. To do this, create a budget and stick to it. Try to avoid overspending and apply for credit only when absolutely necessary.
- Consider a secured credit card. A secured credit card functions similarly to a regular credit card, but requires an upfront security deposit as collateral for your credit line. As you use the card regularly, keep your balance low relative to your credit limit and pay your bill on time every month, you'll be able to establish some positive history on your credit report. Plus, if you pay your balance in full every month, you can do all of this without paying a dime in interest.
As you take these steps to establish good credit behaviors, you'll be able to slowly recover from the impact of your bankruptcy.
Alternatives to Bankruptcy
While bankruptcy can provide some relief from debt, it's not always the best option. Here are a few alternatives to consider that may not have as big of an impact on your credit score.
If you're in a situation where you're struggling with your debt but are still capable of making payments, a debt consolidation loan may help. With good or excellent credit, you may be able to qualify for a lower interest rate on the new loan than what you're currently paying on your debt.
Debt Management Plan
A debt management plan allows you to pay off your debts over three or five years through a credit counseling agency. Your credit counselor will collect payments for your unsecured debts and make payments to your creditors on your behalf.
They can also potentially reduce your monthly payments and interest rates, making the process more affordable. You'll typically need to pay a modest upfront fee and an ongoing monthly fee throughout your plan's term.
Consider a debt management plan if your credit situation isn't the right fit for debt consolidation, but you want to avoid alternatives with more credit consequences.
Debt settlement is the process of negotiating with your lenders to pay less than what you owe. You'll typically go through a debt settlement company, which collects payments from you until you have enough for the company to start the negotiations on your behalf.
During this time, you'll be advised not to make your regular monthly payments on your loans and credit cards. As a result, debt settlement can damage your credit report significantly, though it's typically not as severe as bankruptcy.
Debt settlement companies typically charge upfront and ongoing fees throughout the process, which can get expensive. Debt settlement can be risky and expensive, and it isn't guaranteed to work. If considered at all, it should only be as a final step before bankruptcy.
Think About the Long Term
When you need debt relief, it's natural to focus mostly on what bankruptcy, debt settlement or any other alternative can do for you right now. But because each of these options can affect your credit score and financial situation, it's crucial that you take the time to research every course of action and consider both the short- and long-term effects of each.
Before you go through with one of them, consider consulting with a credit counselor or bankruptcy attorney to get an objective, expert opinion. Credit counselors generally don't charge for this service, and many bankruptcy attorneys offer free consultations as well.
Between your own research and expert advice, you'll have a better chance of choosing the correct path forward.