Is Filing for Bankruptcy Bad for Your Credit Score?

If you’ve racked up a massive amount of debt that you can’t afford to repay, it might be time to think about filing for bankruptcy.

Bankruptcy is a legal process in which heavily indebted individuals can eliminate or settle their obligations to creditors. While declaring bankruptcy comes with significant tradeoffs, it can also offer honest debtors a “fresh start,” according to the U.S. Supreme Court.

The bankruptcy process often involves hiring an attorney, attending mandatory credit counseling sessions, and potentially liquidating any large-value assets under a court-ordered plan. Post-bankruptcy, you may also need to attend a debtor education course – and navigate the detrimental impacts bankruptcy can have on your credit score.

In this article, we’ll walk through the bankruptcy process and learn how it can impact your credit. We’ll also take a look at several alternatives to consider before filing for bankruptcy.

Key Question: How Does Bankruptcy Affect Your Credit Score?

Key Takeaways:

• Bankruptcy results in a significant hit on your credit score in the short term, but can be a tool to rebuild your credit in the long term.
• Depending on the type of bankruptcy you file, bankruptcy can stay on your credit report for up to ten years.
• Rebuilding credit post-bankruptcy involves developing sound personal financial habits, establishing a strong payment history, and rigorously following any court-ordered plans.
• Alternatives to bankruptcy include debt settlement, debt management plans, and debt consolidation loans.
• More than 434,000 individuals filed for bankruptcy in 2023, a 16% rise from the previous year.

What is bankruptcy?

While there are many types of bankruptcy, it’s most common for individuals to file either Chapter 7 or Chapter 13 bankruptcy.

A Chapter 7 bankruptcy is commonly called a “liquidation” bankruptcy since it involves selling eligible assets to settle your outstanding debts. Once that process is completed, any remaining obligations are discharged.

A Chapter 13 bankruptcy, in contrast, is known as a “reorganization” bankruptcy, since it involves coming up with a modified payment plan to satisfy your existing debts. While Chapter 13 does not allow you to discharge debts as easily, you’re also able to retain more of your assets.

Which choice is right for you? Remember, the purpose of bankruptcy is to offer a fresh start financially. If you can achieve that with some modifications to existing debts, Chapter 13 could make sense. If there is no reasonable path to paying off your existing obligations, however, Chapter 7 may be more viable.

Thankfully, individuals don’t have to make this choice alone, says Pamela Foohey, Professor of Law at University of Georgia School of Law. “An attorney should walk you through which chapter is the right choice for you financially,” Foohey says.

In certain situations, however, debtors may not have a choice in which form of bankruptcy they can file. If your current monthly income is above a certain limit, the court may not allow you to file under Chapter 7 at all. This “means test” is one of the common pitfalls that an experienced attorney can help debtors avoid.

How does bankruptcy work?

The bankruptcy court process generally takes between four and six months. If you decide to file for bankruptcy, here is an outline of the steps you can expect:

Step 1: Preparing to file

Before you file, you’ll want to organize and gather relevant financial documents. This includes documentation of your income, assets, and all outstanding debts. At this stage, you’ll also want to find a bankruptcy attorney (it is possible, but not recommended, to file for bankruptcy without a lawyer).

Before you formally file for bankruptcy, you’re also required to take a mandatory credit counseling course to ensure you’re aware of the tradeoffs involved.

Step 2: Filing & creditors’ meeting

Once you’ve completed the preliminary steps, your lawyer will file a formal bankruptcy petition with the court. At this stage, creditors are notified of the bankruptcy proceedings and must halt collection attempts.

After filing, a trustee is assigned to manage your bankruptcy estate and oversee the process. Next comes the creditors’ meeting, commonly known as a “341 meeting” after the bankruptcy code that mandates it. While creditors rarely attend 341 meetings for individual bankruptcy cases, you will need to answer the trustee’s questions under oath.

Step 3: Debt discharge & payment plans

Depending on the type of bankruptcy filed, the next steps may involve the trustee liquidating eligible assets to satisfy creditors (Chapter 7) or implementing a multi-year payment plan (Chapter 13).

Under Chapter 7, debts are considered discharged once court proceedings are complete. Under Chapter 13, however, debts are only considered discharged once the agreed-upon payment plan has concluded. You’ll also need to attend a mandatory debtor education course to satisfy the terms of your bankruptcy.

Post-court, filing for bankruptcy continues to impact debtors for years. In addition to staying on your credit report for up to a decade, bankruptcy can make it more challenging to find private-sector employment, especially for positions that require handling money.

Impact of bankruptcy on credit score

Filing for bankruptcy can have a swift and significant impact on your credit score. If you have good credit going into the process, expect bankruptcy to cause up to a 200-point hit to your credit score.

While this hit can diminish over time, especially if you develop a strong payment history, bankruptcy doesn’t fall off your credit report overnight. A Chapter 7 bankruptcy can stay on your credit report for up to a decade, while a Chapter 13 bankruptcy can remain for seven years.

Depending on your situation, though, the impact of bankruptcy on your credit score may be smaller than you’d expect. Because most individuals who file bankruptcy already have a history of missed payments and poor credit management, bankruptcy can sometimes even benefit your credit.

“When people file for bankruptcy, often their credit score was so low and they were in debt for so long, they benefited from getting rid of unsecured debt,” Professor Foohey says. “The minute you file for bankruptcy, you’ll get a stack of new credit card offerings, which you should shred.”

In fact, the median credit score for people who filed for Chapter 7 increased after filing, according to data from the Consumer Financial Protection Bureau. Because Chapter 13 filers still had their debt for three to five years, their credit scores didn’t rebound as quickly.

How to rebuild credit after bankruptcy

Although there is no quick fix to improving your credit score post-bankruptcy, smart credit management can help you recover over time. This includes meeting all regular payment obligations, maintaining a diverse credit mix, and keeping low utilization ratios on revolving credit lines.

Here are a few more strategies you can implement to effectively rebuild your credit:

• Implement an effective budget. If your personal financial habits led you to bankruptcy in the first place, it’s important to address these issues before taking on future debt. Ensure you have a strong budget in place and consider working with a financial planner.
• Consider secured credit cards. Secured credit cards require an upfront cash deposit to serve as collateral. This can make them easier to qualify for and thus a valuable tool for individuals with poor credit.
• Rigorously follow payment plans. If you filed for a Chapter 13 bankruptcy, you’ll need to make regular payments to your trustee, who will disburse the funds to creditors. Following this payment plan will keep you compliant with the court-ordered process and prevent a mandatory conversion to Chapter 7.

As you follow these steps, remember to regularly monitor your credit score over time. Online credit score services operated by lenders and credit bureaus often allow you to view your scores at no cost. You can also check your credit reports for free at AnnualCreditReport.com.

Remember, improving your credit score post-bankruptcy isn’t a quick or easy process. While you may see improvements within 12 months of filing, substantial increases often take years. For more resources, explore our series of educational articles on building credit.

Alternatives to bankruptcy

Bankruptcy is not a decision to be taken lightly. In addition to long-term impacts on your creditworthiness, you could lose your house, car, or other valuable property after filing. You can also have a portion of your income earmarked for debt repayment.

Before filing for bankruptcy, here are a few other options that may help you manage your debt:

• Debt settlement. Debt settlement involves negotiating directly with your creditors to pay a reduced amount of your loan to extinguish a debt. While debt settlement can lower the amount you owe, it can also have negative credit score impacts and may have tax implications.
• Debt management plans. Certified financial counselors can help you set up debt management plans, which can lower your monthly payments and interest rates. Plan participants typically pay a lump sum monthly to a credit counseling agency, which then pays all of their creditors. Ensure you work with an approved, non-profit agency.
• Debt consolidation loans. A debt consolidation loan involves paying off multiple smaller loans by taking out a new larger one. If you can get a reduced interest rate or lower monthly payments, a consolidation loan could help you more effectively manage existing debt.
• Hardship programs. If an unexpected life event has left you struggling financially, contact your creditors to inquire about forbearance programs. These programs won’t forgive debts, but they can temporarily suspend payments until your financial situation turns around.

Weighed against these possible alternatives, is filing for bankruptcy bad?

There’s no simple answer, and any decision should be undertaken after consulting with both a bankruptcy attorney and an experienced financial professional. Due to the serious consequences associated with bankruptcy, however, it should be considered a last resort after exhausting all other options.

Conclusion

While filing for bankruptcy can offer individuals with unsustainable debt burdens a fresh start, it comes with some significant tradeoffs.

The credit score impact of bankruptcy can be high, likely involving a drop of more than a hundred points. Moreover, bankruptcy can remain on your credit report for up to ten years.

Pursuing professional guidance from a bankruptcy attorney or financial advisor can help you determine whether filing for bankruptcy is the right decision for you. To learn more about the bankruptcy process, read What Gets Discharged During Bankruptcy and What Doesn’t.

Pamela Foohey is a Professor of Law at University of Georgia School of Law. Foohey’s research centers on bankruptcy, business, consumer finance, and commercial law. Her work in business bankruptcy focuses on non-profit entities, with a particular emphasis on how churches and other religious organizations use bankruptcy. She also is a co-investigator on the Consumer Bankruptcy Project, a long-term project studying people who file bankruptcy.