Bankruptcy Effects on Credit Rating

The credit score is essentially the report card representing your financial management skills – the better you manage your money, the higher the score. Likewise, making too many wrong financial moves and going into debt will reduce this score. People typically declare bankruptcy when they need legal intervention to erase or restructure their debt.

So naturally, filing for bankruptcy does have a strong impact on the credit scores too. Luckily, it is possible to rebuild your credit after this stage with specific steps and strategies. This post will cover all of that in more detail.

What is Bankruptcy?

Bankruptcy is a type of legal process that businesses or individuals file when they are incapable of repaying their outstanding debt. This process falls under the purview of federal law with rules noted in the U.S. Bankruptcy Code.

Filing bankruptcy provides relief to financially insolvent people; they can no longer fulfill their debt repayment obligations on time even after trying other solutions. But it stays on the credit report for multiple years. That can make it challenging to qualify for new credit lines in the future.

There are six bankruptcy types available:

Chapter 7

This is the “liquidation” type of bankruptcy that corporations or individuals typically opt for. Filing for this type can result in the discharge of most unsecured debt like personal loans, credit card debt and medical debt. However certain obligations such as child support and back taxes are not forgiven.

Chapter 9

Municipalities like cities, counties, towns and more can opt for this type of bankruptcy to discharge their debts. They can restructure their debts to pay off creditors.

Chapter 11

Chapter 11 bankruptcy is mainly for businesses to reorganize their assets and keep paying off their debt. Individuals who have a lot of accumulated debt may sometimes file for it. This bankruptcy process is more complicated than the Chapter 7 and 13 types.

Chapter 12

This type of bankruptcy is primarily for fishermen and family farmers. It involves modifying a plan for repaying the debt instead of facing liquidation.

Chapter 13

This bankruptcy type can be categorized as the repayment plan version. It suits debtors who still have a regular income and can pay some of their unsecured debts over time. Instead of liquidation, debtors may get a repayment timeline of 3-5 years. It remains on the credit report for 7 years. People can keep some of their vital assets like their car or house if they maintain timely payments.

Chapter 15

Chapter 15 bankruptcy applies for international cases of bankruptcy. Individuals or multinational businesses with debts and assets in many countries can file for this. The U.S. bankruptcy courts and foreign courts work in coordination in these cases.

Most people typically file for either Chapter 7 or Chapter 13 when declaring bankruptcy. So those are the two we will focus on here.

How Does Bankruptcy Affect Your Credit Score?

Creditors check the FICO credit score of individuals to understand their creditworthiness and determine loan eligibility. Payment history constitutes 35% of this score. So, making timely payments is extremely important to maintain a high score.

Having a high credit score implies that the debtor is responsible when borrowing money. Creditors consider them less risky with their money – they allow these debtors to qualify for loans and credit cards with lower interest rates.

Bankruptcy is usually the last resort for debtors when they can no longer make debt payments and creditors may obtain judgment against them. Other debt relief strategies they have tried also have not worked out. This is why filing for bankruptcy significantly lowers the credit score as it signals that you cannot repay your lenders as originally planned.

Generally, filing bankruptcy causes a drop of 100-200 points. The higher that your credit score was before filing, the bigger this drop. For example, a person who has over 700 credit score may lose around 200 points while a person with a 500+ score may notice a smaller drop. Besides that, the type of bankruptcy also influences the degree of credit score decrease. Filing for Chapter 13 will cause a slighter drop in credit score than Chapter 7 bankruptcy.

The timeline of credit score changes post-bankruptcy.

Bankruptcy filing has an influence on the credit score. Yet, the timeline of the process and recovery is different for the Chapter 7 and 13 types.

Chapter 7 Bankruptcy

• Duration on the Credit Report: ≤10 years (from the date of filing)
• Recovery Period: People can see improvements in their credit score within 12-18 months after bankruptcy discharge if they consistently maintain good credit behavior.

Chapter 13 Bankruptcy

• Duration on the Credit Report: ≤7 years (from the date of filing)
• Recovery Period: Given the repayment structure of this type, it is possible that improvements in credit score can start within the repayment period. Making payments on time and using credit responsibly can bring significant improvements in credit scores within 12-18 months.

What are the Factors That Impact Credit Scores?

The FICO credit scoring model considers 5 factors in this calculation.

Payment History (35%)

This factor constitutes 35% of the credit score. That means that making timely payments will have a significant impact on your score.

So you should prioritize this to recover your credit after bankruptcy.

Example: Sara had a car loan and a credit card. She made her bill payments consistently but missed one payment 2 months ago. That causes a drop of 50 points to her credit score.

Credit Utilization Ratio (30%)

The total amount that a debtor borrows does influence their credit score – especially the total amount of the available credit they are utilizing. This is known as the credit utilization rate. Lenders want to see your credit behavior. When someone relies too much on credit (high credit utilization), it gives the impression that they are not financially responsible and have a high risk of becoming a defaulter. This causes a drop in their credit score.

Paying off most or all outstanding balances can reduce the utilization ratio and improve credit scores after they get updated to credit bureaus.

Example: The following is the chart showing the credit utilization of one individual.

Credit Card	Credit Limit	Balance	Rate of Utilization
Card 1	$5,000	$2,000	40%
Card 2	$3,500	$700	20%
Card 3	$6,000	$900	15%
Total	$14,500	$3,600	25%

Key takeaways:

• The debtor has an average utilization rate of 25%. It is decent as keeping the utilization under 30% is best.
• Under 10% is ideal – so the debtor should focus on improving this score.
• Card 1 has a high utilization rate (40%) and can negatively impact credit scores over time.
• Focusing first on reducing credit card debt from Card 1 will likely improve the credit score.

Length of Credit History (15%)

Like any habit, people get better at managing their finances the more they use it. This is why people with a long credit history have a high credit score. Generally, the length of the credit history is calculated based on:

• The oldest credit account
• The newest credit account
• The average age of all the credit accounts

Paying off any loan or closing a credit account does not immediately disappear from your credit history. So, if you closed an account that has a positive payment history, that will still stay on your report for nearly 10 years. This does impact the credit score.

Example: Patrick has one credit card that he opened 10 years ago, a second credit card he got 5 years ago and a third he opened last month. If he closes the first card, his credit history will drop from 10 years to 5 years. This will impact the credit close since his average account age is lower.

Credit Mix (10%)

A debtor’s ability to manage many credit products displays their ability to handle credit responsibly. So, the credit mix constitutes 10% of the FICO score. The scoring models favor a mix of multiple credit types, like personal loans, credit cards, installment loans, lines of credit, etc.

Example: Emma has only personal loans. When she takes a new credit card and starts making payments on it continuously, that may increase her credit score. A mix of different credit products can demonstrate to lenders that Emma is capable of managing credit responsibly.

New Credit (10%)

When someone takes on a new loan or credit, that poses a certain level of risk for the lenders. There is a possibility that the debtor may struggle to pay off the debt payments or even default on it; this means the lenders will lose their money.

Credit scoring systems consider this seriously – that’s why there is a slight drop in the credit score slightly every time there is a hard credit inquiry. This happens after each new loan or credit card application and usually causes a credit score drop of up to 5 points. However, the credit score usually returns to normal after a few months of consistent payments.

All hard inquiries do not affect the credit score similarly.

Positive scenario.

If you are browsing different rates on student loans, auto loans or mortgages, the lenders will likely check your credit. Credit scoring systems understand that you are likely doing rate shopping. They typically consider all these multiple inquiries as just one inquiry.

Note: This counts if the inquiries were made within a short period like two weeks.

Negative scenario.

If you apply for many credit cards even within a short period, each of those hard inquiries are counted separately. So that can cause a significant drop.

Example: Paul applied for 4 new credit cards in one month. Each credit card issuer conducted a hard inquiry for each application – this can cause a credit drop by 20 points. Multiple inquiries in a short period give off the impression that Paul is in urgent need of credit. That can raise concerns about financial stability to lenders and they may consider his high risk.

Immediate vs. Long-Term Impact of Bankruptcy on Credit

Both Chapter 7 and Chapter 13 bankruptcy impacts the credit score significantly. But the degree of the impact and the consequences are not the same for both. In fact, there is a distinct difference in how bankruptcy affects credit scores immediately after filing and also in the long run.

Short-Term Impact on Credit

Filing for bankruptcy has an immediate impact on the credit score. The level of impact can differ depending on one’s existing credit score.

• Someone with a 750 credit score may see a drop of 200-240 points.
• But, someone with a 680 credit score may lose around 130-150 points.

Creditors will consider both these individuals as risky borrowers. So they will have trouble finding good loans or unsecured credit they can qualify for. Plus, you may have limited options to borrow with some of the bankruptcy types. For example, you may need to get court approval to borrow more money.

Long-Term Impact on Credit

The long-term impact that bankruptcy has on the debtor is that it takes 7-10 years to disappear from their credit report. The total impact can differ from person to person depending on:

• The total debt discharged
• Negative to positive accounts ratio on the report

If you want to take new loans or credit cards after bankruptcy while your credit is still low, you can. But you will have a hard time finding good choices. Some creditors you have previously borrowed from may decide to avoid lending to you again. New lenders that offer options may charge extremely high interest.

Besides the credit implications, you may experience problems with other aspects. You may get fewer job opportunities or housing applications.

Debtors may also face societal stigma after filing bankruptcy. That can reduce their feelings of self-worth and negatively hurt their mental health. Since it takes a long time to improve their finances and credit score, they may feel more stress from their unstable situation.

The following table summarizes the overall impact of bankruptcy in a simpler format.

Factor	Chapter 7 Bankruptcy	Chapter 13 Bankruptcy
Type	Liquidation type. The court may discharge most of the debts but sell some of the assets.	Repayment type. The debtor makes timely payments to the adjusted plan over a period of 3-5 years.
Credit Score Impact Level	Severe negative impact. Average drop of 130-200+ points.	Moderate negative impact. Average drop of 100-150+ points.
Duration on Credit Report	10 years	7 years
Impact severity over time	Most damage occurs in the first few years. The degree reduces over time.	The damage to the credit score reduces with each consistent payment during the repayment period.
Recovery Period	It takes a long time to recover.	Comparatively less time needed to recover credit score.
Best Suited For	People with overwhelming debt. Low income. No available funds to repay debts.	People with a steady income who can make payments with a structured repayment plan.

How Do Creditors View Bankruptcy and its Role in Creditworthiness?

Bankruptcy indicates that the person has had a problem managing their debt responsibly. So creditors see it as a warning sign regarding the person – what if they cannot repay their next loan or credit card that the creditor lends? This is why creditors see bankruptcy filing as a negative sign of creditworthiness. The debtor appears as a high-risk borrower with their significantly low credit score.

Plus, bankruptcy stays in the credit report for many years after the filing date. That further negatively impacts their creditworthiness.

Is it possible for Bankruptcy to Improve Credit Score?

Bankruptcy does not directly improve the credit score but does create an opportunity for you to return to a good credit profile eventually. Let’s understand how.

A bad credit score is somewhat like an ACL tear or a fracture. An individual can heal the injury over time if they follow the doctor’s advice well, rest properly and get physical therapy. Similarly, it can take some time to rebuild credit with good financial habits but it is possible.

Generally speaking, someone who has filed for bankruptcy is already at the stage where their credit score is significantly damaged. This is because of several missed payments and possibly collection attempts. Declaring bankruptcy at this point instead of using other methods like debt management will decrease the score further but not by a lot. For example, if you have a 650+ credit score, bankruptcy will cause a drop of around 130-200 points. But if your score is already, say, 480– your score will drop 80-130 points, causing you to be in the 350-400 range.

So after bankruptcy, which basically gives them a clean slate, your credit score can only grow but it will take time. This legal process will eliminate many of your debts, so you will have a fresh restart. You can start paying your credit and loan payments on time, decrease your DTI ratio and follow good habits to rebuild your credit.

It is worth noting that there are other debt-relief options available that you can take to manage your debt. Before opting for bankruptcy, check out other strategies first in case one works for you. Consult with a certified credit counselor or financial advisor to make a more informed decision.

Steps For Recovering Your Credit Score After Bankruptcy

There are certain steps people can take to improve their credit score after the bankruptcy process.

Continue making on-time payments

Multiple debts like child support, alimony and some legal penalties are not legally dischargeable under bankruptcy. So, if there are some repayments that you still have to handle after filing for bankruptcy, prioritize them seriously. Payment history makes up 35% of the FICO score. So even though you faced a big drop in your credit score from bankruptcy, make timely payments to rebuild your credit profile slowly. Use features like automated payments or set reminders to avoid missing payments.

Review the credit report often

Take time to go through your credit reports from all three credit bureaus occasionally. Check for errors like wrong amount-related data or closed accounts shown as open. If you see one, report it immediately to keep your credit history accurate.

Get a new credit card

After bankruptcy discharge you can opt for a new credit card. Responsibly make full payments for the credit card balance to improve your credit score over time. This will help you maintain a good payment history and even increase your credit limit. Both of these factors play a significant role in the FICO score; so prioritize them.

Of course, it is worth noting that it might not be easy to qualify for new credit cards after bankruptcy. In that case, apply for a secured credit card keeping a cash deposit as collateral.

Turn into an authorized user

Another way to rebuild credit score post-bankruptcy is to join another person’s credit card as an authorized user. Typically, people do this alongside their family members or close friends if they have a good credit history. Authorized users can use the primary cardholder’s credit card for purchases and are not legally responsible for repayment.

This is a really useful method for you to rebuild credit after bankruptcy. However, since the primary cardholder takes full financial responsibility, there needs to be mutual trust before adding someone as an authorized user.

Try out a credit builder loan

You can try applying for a credit builder loan with a smaller principal in a restricted account like a CD. Debtors can use this type of loan to quickly build up their credit with timely payments within the set period. After paying off the loan completely, they can keep the amount without any applicable fees like interest or administrative costs.

Get financial advice and support from a credit repair expert

You can consult with a financial advisor, credit repair specialist, specialized attorney or credit counselor for help. They may support you with assessing your financial situation and suggest personalized tips to rebuild creditworthiness. Also they may recommend suitable credit products that will help you build your credit and even provide budgeting guidance.

How Long Will It Take for The Credit Score to Improve Post-Bankruptcy?

While you will see a significant drop in your credit score after bankruptcy, it’s luckily not a permanent situation. You can increase your credit score with time and effort. Making responsible financial decisions and timely payments consistently can improve your credit score within 12-18 months. It will likely take around 2-3 to see significant results.

Conclusion

Bankruptcy does have a notable effect on credit scores but it is not the final nail in the coffin of your financial future.

This is essentially a lifeboat for those who are financially insolvent and other methods of debt relief have not worked out for them. The bankruptcy process removes all or most of their debt but that further significantly damages their credit score. Depending on the type of bankruptcy and the credit score at the time, the damage can vary between 80 to 250 points. Plus, it stays in the debtor’s credit history for multiple years.

It is possible to slowly but surely grow back your credit score with responsible financial habits, using a secured credit card and more. As long as you avoid making moves that initially caused you to fall into debt, you can recover your score and financial stability.

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About The Author:

Lyle Solomon has extensive legal experience, in-depth knowledge, and experience in consumer finance and writing. He has been a member of the California State Bar since 2003. He graduated from the University of the Pacific’s McGeorge School of Law in Sacramento, California, in 1998 and currently works for the Oak View Law Group in California as a principal attorney.