When you file for bankruptcy, you should be aware that this bad record will remain on your credit report for 7-10 years, resulting in an instant 100-200 point decline in your credit score. Yes, it hurts, but the reason you choose bankruptcy is to have a “second chance” at managing your money, which includes efforts to improve your financial future and credit score.

According to attorney David Chami, managing partner of Consumer Attorneys, the first step is to determine whether bankruptcy is the best option. A call to a nonprofit credit counseling firm might assist you in determining whether there is another debt-relief alternative that will fix your problem.

“Use this service (nonprofit credit counseling) to actually see if bankruptcy is necessary,” Chami told me.

Think of bankruptcy as a trade-off. It eliminates or reduces unpaid debt, but it also labels you as a credit risk, making it difficult to obtain a credit card, a personal bank loan, or a mortgage in the short term and potentially damaging to your credit in the long run.

“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 told reporters.

Credit score harm is worse for persons with good credit who consider declaring bankruptcy due to a medical emergency, business failure, divorce, or the death of a key pay earner. They are the ones who could see a 150-200 point drop in their credit score.

Even while filing bankruptcy remains on your credit report for 7-10 years, it has no effect on your ability to seek credit during that period as long as you pay your debts on time. For example, the schedule for Chapter 7 bankruptcy is a few months, and many people obtain credit cards soon after release. After filing for bankruptcy, you may be able to obtain a car loan (albeit at a hefty interest rate).

“The discharged debtor must remain current on all regular obligations that survived the bankruptcy,” stated George Vogl, managing director of Stretto, a bankruptcy technology and services company. “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.”

If you’re not sure what to do, a nonprofit credit counselor can help you design a strategy. If you stick to a strict budget, pay your bills on time, and utilize a secured credit card, credit rating agencies can raise your credit score to a decent level in just 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.”

How Does Bankruptcy Affect my Credit?

When you declare bankruptcy, the value of your assets is often divided among people to whom you owe money. This can include your home, car, recreational equipment, and jewelry – anything but the necessities. Depending on your salary, you will be required to make debt payments for up to three years.

It sounds dark, yet there is a silver lining. Once you’ve been declared bankrupt, you won’t have to deal with creditors again. Lenders will also be required to suspend most sorts of court proceedings against you. And, most importantly, you will usually be ‘discharged’ – that is, free of your debts – after one year.

Immediate Impact of Bankruptcy on Credit

If you know your credit score before filing for bankruptcy, prepare to watch it plummet. Filing for bankruptcy has an immediate impact on your credit score. The significance of the impact depends on the score you carried into the bankruptcy filing procedure.

Read Also: How to Negotiate With Creditors and Collection Agencies

A person with an average 680 score would lose 130 to 150 points in bankruptcy. Someone with an above-average 780 score would lose 200 to 240 points. In the end, both individuals would be classified as risky borrowers, making it difficult or impossible to obtain loans or unsecured credit.

Keep in mind that depending on the type of bankruptcy, you may be unable to borrow funds without court approval. In the early phases of bankruptcy, and in certain circumstances throughout the process, the financial constraints you’ll encounter will make it exceedingly difficult to obtain a vehicle loan or mortgage until your bankruptcy is dismissed.

Long-Term Effects of Bankruptcy on Credit

One disadvantage of declaring Chapter 7 bankruptcy is that it will have a negative impact on your FICO score for ten years. A Chapter 13 filing, which involves partial repayment, stays on your record for seven years after you receive a Chapter 13 discharge or dismissal.

The impact of bankruptcy on your credit score varies depending on the amount of debt discharged and the ratio of positive to negative accounts on your credit report. This is because important credit score variables like 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.

How to Rebuild Credit After Bankruptcy

Though you cannot change the length of time bankruptcy remains on your credit report, you can take action to accelerate the rate at which your credit score rebounds.

First, do not fall for a credit restoration company’s pitch that promises to restore your credit rating for a charge. It cannot be done. These are scams. The only way to recover credit is to become a shining example of financial prudence.

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.

Alternatives to Bankruptcy

As Chami says, speaking with a nonprofit credit counseling service before contacting a bankruptcy attorney might help people examine their choices and get peace of mind about whether or not to file bankruptcy.

The 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.

Finally

While bankruptcy has major repercussions, it can also lead to a fresh start. Seek advice from a nonprofit credit counseling agency or a bankruptcy attorney. Filing under Chapter 7 or Chapter 13 may be your best alternative.

Educating oneself about available options might be overwhelming while avoiding what may feel like a financial avalanche. Think of it as the storm before the calm.