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Bankruptcy does severe, long-lasting damage to your credit. Of all the possible options for managing your debts, it should be considered a last resort. Still, it's often preferable to the outcome it was designed to prevent—financial ruin from insurmountable debt.
How Does Bankruptcy Work?
The bankruptcy process, overseen by special federal bankruptcy courts, shields individuals who can't meet their financial obligations from losing everything to creditors and provides a framework that may allow them to pay back some of what they owe.
Filing for bankruptcy can bring relief from overwhelming debt, but it also has a serious, negative impact on your credit and remains on your credit report for seven or 10 years, depending on the type of bankruptcy.
- Chapter 7 bankruptcy, also known as a liquidation bankruptcy or straight bankruptcy, is available to individuals who can show their income is too low to cover their outstanding debts. It erases many debts altogether, but it may require you to sell or give up assets, including real estate, investments and savings that exceed a basic exempt amount, with the proceeds to be divided among your creditors. Chapter 7 bankruptcy is typically a fairly quick process, and often concludes three to six months after you file.
- Chapter 13 bankruptcy, sometimes called reorganization bankruptcy, is designed for those with enough income to afford at least partial repayment of debts. It allows you to retain more property and sets up a three- to five-year repayment period, during which time you must make regular payments to creditors. Typically, these payments will not repay your debts in full, but they allow creditors to recoup more of what they are owed than is often possible in a Chapter 7 bankruptcy.
All bankruptcy applicants must complete court-approved credit counseling, and eligibility precludes having filed for bankruptcy in the preceding eight years in the case of Chapter 7 or the previous six years in the case of Chapter 13.
Neither type of bankruptcy eliminates all financial obligations—alimony, child support and back taxes are not excused, and certain student loans cannot be erased automatically—but at the conclusion of each bankruptcy proceeding, assuming you have fulfilled all the court's requirements, most of your remaining debts, including unpaid rent, utility bills, credit card balances and loan payments are considered discharged: You are no longer responsible for them, and your creditors are forbidden from trying to collect them.
Note, however, that even though bankruptcy forgives your obligation to cover missed payments, property obtained through secured debt, such as a home that's still mortgaged or a car with a loan that's gone unpaid, can still be seized by your creditors in accordance with your original loan agreements.
How Bad Can Bankruptcy Can Be for Your Credit?
Bankruptcy (and the missed debt payments that often precede it) can devastate your credit scores and make it difficult for you to qualify for loans or new credit card accounts.
A Chapter 13 bankruptcy remains on your credit report for seven years from the date you file bankruptcy with the court, and a Chapter 7 bankruptcy remains for 10 years from the filing date.
Bankruptcies also have a significant negative effect on your credit scores. Their impact on your scores diminishes over time, but they will tend to lower your credit scores as long as they appear in your credit reports.
How Bankruptcy Can Make It Hard to Get More Credit
Some lenders will refuse your loan application as long as a bankruptcy appears on your credit report. Other lenders, typically those focused on subprime borrowers, may accept your loan application once your bankruptcy is several years old—but you can expect them to charge steep interest rates and fees, and to offer relatively low loan amounts or borrowing limits.
It's Possible to Recover From Bankruptcy With Time
As time passes following a bankruptcy, its negative effect on your credit score lessens on its own until its entry is automatically removed from your credit report.
Rather than simply waiting for a bankruptcy to stop harming your credit, however, you could be taking steps to improve your credit scores. The key to this is establishing a pattern of on-time monthly payments that are reported to the three national credit bureaus (Experian, TransUnion and Equifax). While that might seem impossible if you cannot qualify for new loans or credit, here are options that can help you do exactly that:
- Secured credit card: Secured credit cards are good options for those with bad or no credit history. Getting one requires putting down a cash deposit, and the amount of the deposit typically becomes your borrowing limit. (If you fail to pay your bills, the lender can take the deposit.) If you use the card every month, even for small transactions, and always make your payments on time and ideally in full, you can establish a history of positive payments on your credit reports.
- Credit-builder loan: Typically available through credit unions, community banks and online lenders, these loans are specifically designed to help rebuild credit, with the added benefit of helping you save money. With a credit-builder loan, the amount you borrow—usually $1,000 or less—is placed in an interest-bearing savings account you cannot access until the loan is paid in full. You make monthly installment payments that include interest for a term of six to 24 months, and when you're done, the funds are yours. (Some credit unions let you keep some or all of your interest payments.)
- Experian Boost®ø: If you don't have many credit accounts to your name after a bankruptcy, getting recognized for on-time payment of your utility, telecom and other bills can help you build your score. Experian Boost can add eligible payments to your credit report, which can give your scores a lift, instantly.
Before taking out either a secured credit card or a credit-builder loan, confirm with the lender that your payments will be reported to all three credit bureaus. As long as they are, and as long as you make every monthly payment on time without fail, both products will tend to promote improvement in credit score.
As you allow time to pass and work to rebuild your credit score after a bankruptcy, you'll eventually begin to receive offers for credit cards and loans. Don't take on debt you don't need or can't handle, but consider accepting one or more of these, even if their interest rates are high. Using them prudently can help you build up your credit even further. Eventually, you'll be able to put your bankruptcy, and its difficult consequences behind you.