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What Is Bankruptcy And How Does It Affect My Credit?

4-minute read

Bankruptcy can be a scary thought for anyone in the midst of a financial crisis. Typically, bankruptcy comes along with turmoil such as an illness or divorce. With such tumultuous events in your personal life, it can be difficult to find the energy to focus on your financial life.

Although most people associate bankruptcy with bad financial news, the details of bankruptcy can be confusing. Let’s take a closer look at how bankruptcy can affect your credit. 

How Bankruptcies Work

First, understanding exactly how bankruptcy works is important. 

Generally, bankruptcy helps you find a way to relieve you of your debt. However, the entire bankruptcy process is very complicated. It’s likely you’ll need an attorney to guide you through your specific situation. With the help of a bankruptcy attorney, you can ensure a smooth process as you follow all of the regulations. 

Bankruptcy is conducted in a court setting with a judge and court trustee that can objectively analyze your assets and liabilities. You’ll need to file for bankruptcy and show you can no longer pay your bills. If the court decides to discharge your debts, you’re no longer required to repay them. 

After going through the bankruptcy process, you’re effectively given a fresh start. You have the opportunity to clean up your financial life and move on. 

Three Types of Bankruptcies

Not all bankruptcies are created equally. There are several different options for businesses and individuals, but today we’ll cover the types of bankruptcies available for individuals. 

Before you decide to file for bankruptcy, you should consult a bankruptcy attorney or financial professional to determine the best option for you. 

Chapter 7 Bankruptcy 

With Chapter 7 bankruptcy you’re able to discharge your debts while holding onto “exempt” property. Any property that’s considered “non-exempt” will be sold to partially repay your creditors. 

Some examples of exempt property might include your home, your work equipment and government benefits. Some examples of non-exempt property might include your stock portfolio, vacation home and any cash on hand. However, the exact classification of your property is determined by the court. 

The non-exempt property will be sold by a court-appointed trustee in your name. It can be a painful 4-month process that strips your life down to the bare essentials. When the process is over, you’ll be cleared of some debts.

It’s important to keep in mind that not all debts can be cleared through filing for Chapter 7 bankruptcy. For example, domestic support obligations can’t be cleared through this method. 

Chapter 11 Bankruptcy

Chapter 11 bankruptcy is specifically designed for businesses in distress. You’ve likely heard about high-profile retailer stores filing for Chapter 11 bankruptcy in the news. Usually, these are considered a form of reorganization through bankruptcy for struggling businesses. The business is allowed to stay open while they restructure to repay its creditors. 

If you struggled to qualify for Chapter 13 bankruptcy, Chapter 11 is an option for individuals. It’s especially useful if you have a high debt burden that exceeds the limit of Chapter 13 restrictions. 

Chapter 13 Bankruptcy

Finally, it’s time to uncover how Chapter 13 works. With this method of bankruptcy you won’t be required to sell almost everything you own to repay the debt. Instead, your attorney will negotiate with the bankruptcy court for a revised repayment plan you can afford. The outlined plan is usually for a repayment timeline between 3 to 5 years. 

Typically this option is best for high income earners. If you’ve fallen behind on payments but have the income to turn it around, then this is a good option. In most cases, Chapter 13 bankruptcy is used as a way to catch up on mortgage and car payments. 

What Will My Credit Score Be After Bankruptcy?

After you file for bankruptcy, your credit will be affected immediately. Unfortunately, bankruptcy won’t disappear from your credit reports overnight. It’ll remain on your credit reports for up to 10 years from your filing date. As long as the bankruptcy appears on your credit report, it’ll have a negative impact on your credit score. However, FICO® claims the weight of the bankruptcy lessens over time.

If you had a perfect credit score, you should expect a larger drop than someone with a median credit score. It’s possible your score could drop dramatically to leave you with a credit score in the lower 500s. 

Should I Declare Bankruptcy?

Before you choose to declare bankruptcy, take a closer look at your debts. Determine which debts could possibly be discharged via bankruptcy. Think about a realistic repayment timeline with your current strategy. Look into getting very serious about repaying your debt through either the avalanche or snowball method. 

If repaying your debt will take years or decades, you should consult with a financial professional or bankruptcy attorney. They may be able to help you determine whether or not bankruptcy is a good idea for you. 

How Long Does It Take To Reestablish Credit?

Rebuilding your credit after bankruptcy can be difficult. With focused effort, you can rebuild your credit score over time.

Don’t expect to rebuild your credit overnight. Start with small steps. Open a new credit card account and pay it off in full each month. If you have any debts that weren’t discharged via bankruptcy, like your student loans, make an effort to pay them down now. Every step will take you closer to a higher credit score.

Buying A Home After Chapter 7, 11 Or 13 Bankruptcy

After filing for bankruptcy, you’ll need to consistently work on your credit score. As you rebuild, you can start to think about securing a mortgage for your next home purchase. However, you need to keep waiting periods in mind

For FHA home loans you may need to wait up to 2 years after filing for bankruptcy before applying for a mortgage. However, VA loan applicants who filed for Chapter 13 just have a 1-year waiting period. Check into the bankruptcy restrictions surrounding your desired home loan before you submit your application.

The Bottom Line

The consequences of declaring bankruptcy can be extremely damaging to your credit. It’s not a decision you should make lightly. Take the time to research your options and consider all repayment plans before filing for bankruptcy.

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