Bankruptcy can shield you from financial ruin when debts become insurmountable. However, it has severe, long-lasting negative impacts on your credit and is best considered a last-resort option.

How Does Bankruptcy Work?

Bankruptcy protects individuals who can’t pay their debts from losing everything to creditors. In the U.S., special federal courts oversee bankruptcy, providing a framework to pay back part of what you owe.

There are two types of bankruptcy available to individuals in the U.S.: Chapter 7 and Chapter 13. Each has specific qualifying criteria required by the courts.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy, also known as liquidation bankruptcy, is available to individuals whose income is too low to cover their outstanding debts. It erases many debts but may require forfeiting assets worth more than a basic exempt amount. A court-appointed trustee sells forfeited assets, and proceeds are divided among creditors. Typically, Chapter 7 bankruptcy is finalized within four to six months after filing.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy, or a wage-earner’s plan, is for those with enough income to afford at least partial repayment of their debts. It allows you to retain more property than Chapter 7. A three- to five-year repayment plan is set up, and after this period, remaining debts are forgiven. Chapter 13 may not repay all debts in full but allows creditors to recoup more than in a Chapter 7 bankruptcy.

Limitations and Requirements

Neither type of bankruptcy eliminates all financial obligations. Alimony, child support, and back taxes are not excused, and certain student loans cannot be erased automatically. However, assuming you fulfill all court requirements, most other forms of debt are discharged, and creditors are forbidden from collecting them.

All bankruptcy applicants must complete court-approved credit counseling. Eligibility precludes having filed for bankruptcy in the preceding eight years for Chapter 7 or the previous two years for Chapter 13.

Why Is Bankruptcy So Bad?

The negative consequences of bankruptcy are numerous:

Loss of Home or Car

If you are behind on payments on a mortgage or auto loan, bankruptcy can temporarily halt lenders from foreclosing on your house or repossessing your car. However, it may not ultimately prevent them from seizing those assets. A Chapter 13 repayment plan can help you catch up on missed payments, but Chapter 7 may not stop creditors from seizing collateral if you don’t make payments, reaffirm the debt, or redeem the property.

Filing and Attorney Fees

Filing for bankruptcy requires paying a court administration fee and additional court-imposed fees. Hiring a bankruptcy attorney is advisable, though not obligatory. If you file Chapter 7, you’ll need to pay your lawyer up front. In Chapter 13, legal fees can be factored into your repayment plan.

Credit Score Impact

Bankruptcy is recorded on your credit reports and remains there for seven years (Chapter 13) or 10 years (Chapter 7). A bankruptcy has a deep, long-lasting negative impact on your credit scores. The number of points your scores fall depends on your scores before filing and whether missed payments lowered your scores significantly prior to bankruptcy.

Difficulty Getting New Credit

Some lenders decline credit or loan applications from any borrower with a bankruptcy on their credit report. Other lenders may accept applications after several years but typically charge high interest rates and fees.

How to Rebuild Your Credit After Bankruptcy

It can take several years for your credit scores to begin recovering after a bankruptcy filing. However, you can start rebuilding your credit immediately using these proven measures:

Get a Secured Credit Card

To get a secured credit card, put down a cash deposit that serves as your borrowing limit. Use the card responsibly, make timely payments, and you can establish a history of positive payments on your credit reports. Eventually, the lender may convert you to an unsecured credit card.

Take Out a Credit-Builder Loan

Credit-builder loans help establish or rebuild credit while helping you save money. The amount you borrow is placed in a savings account you cannot access until the loan is paid in full. Making timely payments adds positive information to your credit reports, and you receive the funds upon completion.

Become an Authorized User

Ask a friend or family member with good credit to add you as an authorized user on one of their credit card accounts. This adds the account’s full history to your credit reports, positively impacting your credit score.

Seek a Cosigner

To improve your odds of getting approved for a loan with favorable terms, ask a loved one with good credit to cosign your loan application. If you’re approved, you’re responsible for payments, but the cosigner agrees to pay off the loan if you can’t.

Try Experian Boost®

Experian Boost can add eligible utility, cellphone, and other bill payments to your Experian credit report, lifting your scores instantly.

The Bottom Line

Bankruptcy can relieve the stress of insurmountable debt, but it severely impacts your credit. While it can limit or block your ability to borrow money and may lead to loss of property, its effects will fade over time. Track your credit’s recovery by checking your FICO® Score for free from Experian. Eventually, you can put bankruptcy and its consequences behind you.

If you ever need expert assistance or guidance on your credit journey, don’t hesitate to reach out to the Nerds! Additionally, stay updated with the latest tips and information by following us on Facebook, Instagram and TikTok!