How Does Bankruptcy Impact My Credit Score?

No one sets out with the goal of one day declaring bankruptcy. Everyone wants to be financially stable and independent, but unexpected challenges can arise and result in large amounts of debt. If you find yourself in that situation and you’re considering bankruptcy, you probably have many questions about the possible effects. One of the most common is, “how does bankruptcy affect my credit score?” Keep reading to find out.

What is a Credit Score?

Let’s begin with the basics. A credit score, or FICO® score, is a number between 300 and 850 that attempts to reflect the significant financial decisions you’ve made. Your credit score drops, for example, when you default or make a late payment on a debt. Whereas an established pattern of making payments on time will increase it. Three companies – Equifax, Experian, and TransUnion – track and assign your credit score, and it can have a significant impact on your ability to do everything from borrowing money to getting a job.

What Factors Affect Your Credit Score?

Credit card payments, mortgage payments and rent payments are three types of debt that will have the largest impact on your credit score. The rules around another common type of debt – medical debt – are currently changing, thanks to pressure from the Consumer Financial Protection Bureau. 

There has long been debate about whether or not medical debt should affect credit scores. This is because few people actually choose to take on medical debt, and those that are forced to usually have no idea how much their treatments will end up costing. If this has previously caused issues on your credit report, read up on how the overhauled rules on medical debt might affect you.

Can Bankruptcy Permanently Ruin Your Credit?

Bankruptcy is one of the single largest events that can affect your credit score, and the immediate impact of bankruptcy is substantial. A person with previously solid credit (700+) will see their credit score drop by about 200 points. A below-average to average credit score won’t drop as much. That’s one important factor to keep in mind. If your credit score is good, you will be penalized more heavily than if your credit score is average or worse.

The good news is that the effect is not permanent. In fact, you can start rebuilding credit immediately after bankruptcy is filed. The process takes some time, but financial institutions offer products like secured credit cards and credit-builder loans that can help. Just be sure to make your payments regularly and on time and practice smart spending habits. Financial institutions will look favorably on your efforts to rebuild credit even if you have a bankruptcy on your record.

The effects of bankruptcy can be different, depending on the type of bankruptcy. These are the three most common types of bankruptcy for individuals in the US.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy, also known as “liquidation,” is the most common type of bankruptcy in the United States. A liquidation plan is created, the individual’s nonexempt property gets sold and the proceeds are used to service existing debts. A judge then orders all remaining debts to be discharged. Chapter 7 Bankruptcy can affect your credit score for up to ten years.

Chapter 11 Bankruptcy

Chapter 11 bankruptcy is mostly filed by businesses because under federal law, this is the only bankruptcy option allowed for LLCs, corporations and partnerships. While individuals may file for Chatper 11 bankruptcy as well, it’s less common because Chapter 11 is typically more costly, complex and risky than filing for Chapter 7 or 13. Chapter 11 Bankruptcy can also affect your credit score for up to ten years.

Chapter 13 Bankruptcy

Also called “reorganization,” Chapter 13 bankruptcy allows individuals to repay creditors over a period of three to five years. The benefit is additional time to pay off debts and the chance to renegotiate settlements which typically means the individual has to pay far less than the original debt. Chapter 13 Bankruptcy can affect your credit score for up to seven years.

Is Bankruptcy Right For You?

Imagine Person A and Person B both have $30,000 in debt and are considering bankruptcy. 

The difference is that Person A has a credit score of 750 whereas Person B has a credit score of 550. Both will have $30,000 debt discharged if they declare Chapter 7 Bankruptcy, but the cost for Person A is significantly higher than for Person B. 

That’s because Person A will lose about 200 points to their credit score; Person B will only lose about 100 points. Person A’s new credit score will be ~550; Person B’s new score will be ~450.

Obviously, it’s more worth it for Person B to declare bankruptcy, but it might also be worth it for Person A too. It’s up to you to assess your circumstances and decide if bankruptcy is the tool that will best position you to move forward financially. 

But you don’t have to make the decision alone. In fact, you shouldn’t make this decision alone. Gather as much information as you can, then consult an experienced bankruptcy attorney so you can be sure you understand all of the ramifications of your decision.

There’s no shame in declaring bankruptcy, and it’s not the end of the world for your personal finances. It’s a powerful tool you have at your disposal in the event that your debt burden becomes unmanageable, and if you commit to rebuilding your credit afterward, it can be one of the best financial decisions you’ll ever make.