How Does Bankruptcy Affect Your Credit?

One of the major reasons folks put off filing for bankruptcy is that they’re afraid of how it will impact their credit score. But how does bankruptcy affect your credit? And can your credit ever recover from the hit?

Generally speaking, the answers to those questions are (1) not as badly as you may think, and (2) yes, you can. Below, we discuss what to expect when it comes to bankruptcy and your credit score.

What Factors Determine How Your Credit Will Be Affected?

What Was Your Credit Score to Begin With?

If your credit is good and you file for bankruptcy, your credit score will take a hit by a few hundred points. Several years ago, FICO released several mock scenarios showing that regardless of where your credit is at right now, your score will be reduced to around 550.

But if you have multiple accounts in collections and defaults on your credit report, your credit is probably already in the 500-600 range. So the worse your current credit rating is, the less likely you are to see your credit score severely diminished by a bankruptcy.

How Much Debt Do You Have?

The amount of debt discharged or forgiven in either a Chapter 7 or Chapter 13 bankruptcy will impact how far your credit score falls. If your bankruptcy discharges huge amounts of debt, your score will fall more than someone who discharges fewer debts.

What Is Your Debt to Income Ratio?

One-third of your overall credit score is determined by your debt-to-income ratio. This is true for those who don’t have bankruptcies on their credit report as well. High debt-to-income ratios lower your credit score while the reverse will improve your credit score.

What Is Your Payment History?

Your credit score is a reflection of your overall payment history. The bankruptcy itself counts as a black mark on your credit report as do any discharges you receive. Those qualify as non-payments. If you do file for bankruptcy, you will need to ensure that you repay any debts that survive in order to rebuild your credit.

Chapter 7 vs. Chapter 13 Bankruptcy

When you file for Chapter 7, all unsecured debts that are currently on your credit report are wiped away so long as they are included in the bankruptcy. A Chapter 7 bankruptcy will remain on your credit report for the next ten years. But the further back it is in time, the less harm it will do to your overall credit rating. Potential lenders will consider newer positive credit information to be more important than older negative credit information.

Chapter 13 bankruptcies will stay on your credit report for the next seven years. Since Chapter 13 bankruptcies usually take five years to complete, the mark on your record will usually be gone two years after your bankruptcy is complete.

Rebuilding Your Credit After Bankruptcy

The sooner you file bankruptcy, the sooner you can start to rebuild your credit. If you’ve been mired in debt, you will have a chance to continue to make payments on secured loans such as your mortgage or your car. Keeping up with these payments will provide evidence that you have your finances under control.

Other steps you can take include:

Opening a secured credit card;
Obtaining a secured loan;
Making timely payments on outstanding debt; and
Keeping credit card balances under 30% of your spending limit.

Lenders know that you won’t be able to file bankruptcy again for several years. But interest rates will be high. You will want to make small purchases on your credit card and repay these debts in a timely fashion. This is a great way to rebuild your credit.

Can Bankruptcy Improve My Credit Score?

Probably not. But while the bankruptcy itself counts against you, it also improves your debt-to-income ratio. So these factors work against one another to stabilize your credit.

Most people who file for bankruptcy will find that their credit score is actually higher than it was one to two years after filing. It does, however, require smart budgeting and decision making.