When you file for bankruptcy, it’s usually because you have no other option for your finances.
Although it might be the right choice for your situation, the decision to file for bankruptcy will have a negative impact on your credit. When you file for bankruptcy, you are indicating that you have struggled to responsibly handle your debt. With that red flag on your credit report, obtaining loan approvals can be difficult for years to come.
Let’s take a closer look at how bankruptcy impacts your credit score. Plus, explore what you can do to improve your credit score after filing for bankruptcy.
What Is Bankruptcy?
First things first, what are the mechanics of declaring bankruptcy?
According to the United States Courts, “bankruptcy helps people who can no longer pay their debts get a fresh start by liquidating assets to pay their debts or by creating a repayment plan.”
When you move forward with bankruptcy, it could provide a pathway forward without crushing debts holding you back. But the process highlights that you’ve been unable to make good on your promises to creditors.
Of course, there are many legitimate reasons to file for bankruptcy. Regardless of your reasons, though, creditors will be wary of working with someone who has filed for bankruptcy in the past. After all, the creditors want to make sure borrowers are able to repay the loan. If you have filed for bankruptcy before, it sometimes means that a creditor didn’t get their full repayment.
As an individual, you can file for bankruptcy via Chapter 7 or Chapter 13 of the U.S. Bankruptcy Code. Here’s a closer look at both.
When you file a Chapter 7 bankruptcy, the court appoints someone to oversee the sale of assets to cover some of what you owe to your lenders. Some assets are exempt from the liquidation sale. But any proceeds from the sale will go straight to your lenders.
After you’ve sold off all necessary items, the court will eliminate the remainder of your eligible debts by discharging the bankruptcy. When the debts are discharged, it means that the lender can no longer try to collect the debt from you.
At the end of the day, a Chapter 7 bankruptcy may give you a clean slate of sorts. But the reality is that you might be required to sell off some assets that you’d rather not part with. Additionally, you’ll have to pass a “means test” before pursuing this option. If you earn more than the state’s median income, you might not qualify for this option.
Unlike a Chapter 7 bankruptcy, a Chapter 13 bankruptcy isn’t designed to clear all of your debts entirely. Instead, it offers a chance to restructure your debts into a more affordable payment plan.
Typically, the payment plan stretches out for a three- or five-year term. During that time, you’ll make monthly payments to pay down your debt. If there is debt remaining at the end of the period, it might be eliminated.
How Bankruptcy Impacts Your Credit Score
If you are in significant financial distress, filing for bankruptcy may be the appropriate course of action. But the debt relief will have a major impact on your credit score. Here’s what to expect after you file for bankruptcy.
Credit Score Suffers
Regardless of what your credit score was before the bankruptcy filing, you’ll likely see a big hit to your score when the red flag hits your credit report.
According to Debt.org, the number of points “lost” will vary based on where your credit stood before the bankruptcy. For example, a person with an average credit score of 680 might see it drop by around 130 to 150 points. But a person with an above-average credit score of 780 could see their score drop by around 200 to 240 points.
If you already have a bad credit score, in the 400s or 500s, there’s less to lose when filing for bankruptcy.
Difficult to Get Financing
When your credit score drops, it’s more challenging to lock in financing opportunities for big purchases. Although not impossible to get financing, having a bankruptcy on your credit report is a major red flag for lenders.
Since most of us rely on credit for major purchases, like a home or vehicle, this can become a big problem for our finances. After all, how many of us can afford to purchase a home or vehicle in cash?
Even if you are able to obtain a loan with a bankruptcy on your credit report, you’ll likely pay significantly higher interest rates. Unfortunately, a higher interest rate could amount to paying much more for the same purchase.
For example, let’s say that your credit score tanks after a bankruptcy. You are working on rebuilding your credit score. But due to bad timing, you have to replace your vehicle with bad credit. With that, you have to pay an interest rate of 7% for your 72-month loan of $20,000. By the end of the loan term, you’ll have paid $4,500.57 in interest.
In contrast, someone with a better credit score and no bankruptcy could lock in a lower interest rate of 4%. If all other details are the same, they will pay $2,529.06 over the life of the loan. That’s a significant saving!
When you file for bankruptcy, the record stays on your credit report for between seven to ten years.
When filing a Chapter 7 bankruptcy, it remains on your credit report for ten years. When filing a Chapter 13 bankruptcy, it will remain on your credit report for seven years. Even after that point, the memory of your bankruptcy will live on in the public records. With that, future lenders could still track down the information before deciding to grant you a loan, even if it’s too old to affect your credit.
Since the mark of bankruptcy stays on your credit report for years, it will have long-term impacts on your financial future. It could delay your plans for homeownership and make it challenging to find low-interest loans when making big purchases.
How to Rebuild Your Credit Score After Bankruptcy
A bankruptcy could stick around on your credit report for up to a decade. However, you don’t have to wait for the bankruptcy to drop off your credit report to make big improvements to your credit score.
Monitor Your Credit Report
Credit reports serve as the base for your credit score. A credit report with negative information will lead to a bad credit score. With that, it’s important to keep an eye on your credit report to make sure all of the information is reported correctly.
If you spot incorrect negative information, removing it could help your credit score improve. It’s a good idea to check your credit reports at least once a year. You can tackle this financial to-do for free at AnnualCreditReport.com.
Make On-time Payments a Priority
Payment history is the single most important factor in your FICO score. In fact, it accounts for 35% of your FICO score. This makes sense because future lenders want to know if you have paid your bills on time.
When you have a bankruptcy on your credit report, that will negatively impact your payment history because you didn’t repay the debt in the originally agreed-upon time frame. With that, focusing on making on-time payments is essential to rebuilding your credit score.
Of course, keeping up with your payments is sometimes easier said than done.
If possible, try setting up autopay. Most bill providers offer this option to help borrowers from forgetting their payment deadlines. It’s a helpful tool because sometimes life gets busy, and it’s easy to forget about a bill.
However, autopay isn’t always the answer. If there’s a deeper cash flow issue, then you could be missing payments because you simply don’t have the funds when you need them. Typically, you can see this problem coming. With that, try to reach out to your lender as soon as you know you’ll miss a payment. Sometimes, the lender will offer a helping hand in the form of a temporary forbearance or change of due date. In any case, it never hurts to ask!
Consider a Credit-builder Loan
A credit-builder loan is exactly what it sounds like. It’s a loan that can help you build credit. Plus, it can help you build savings at the same time.
Here’s how a credit-builder loan works.
The process starts with getting approved for a credit-builder loan. Once approved, you won’t receive any funds upfront. But you will start making monthly payments just like a regular loan.
Each month, the lender will keep the interest portion of the loan. But the principal portion is tucked into a savings account or certificate of deposit in your name. When you reach the end of the loan term, you’ll get access to these savings.
With each billing cycle, the lender will report your payment status to the credit bureaus. If you make on-time payments, your credit score will likely improve. But if you miss payments, a credit-builder loan can do more harm than good.
Keep Your Credit Utilization Ratio Low
Your credit utilization ratio belongs to the debt category which makes up 30% of your FICO score, making it an important scoring factor.
Essentially, your credit utilization ratio measures how much you are spending on your credit cards against how much you have available to spend. For example, let’s say you have a credit card with a $10,000 credit limit. If you have a balance of $8,000, then your credit utilization ratio on that account would be 80%.
A lower credit utilization ratio is better for your credit score. Knowledgeable experts recommend keeping your credit utilization ratio under 30% for VantageScore and under 10% for FICO scores because higher ratios can negatively impact your scores. In order to lower your credit utilization ratio, you can pay off debt or increase your credit limits.
Consider a Secured Credit Card
Many turn to a secured credit card to build credit. Here’s how it works.
After you are approved for the secured credit card, you’ll make a deposit that acts as your credit limit for the card. At the end of the billing period, you’ll have to make a payment on the credit card. But if you don’t make an on-time payment, the credit card issuer can claim your deposit to cover your spending.
Ultimately, this reduces the risk for the credit card issuer. But if you are making your payments on time, this habit can help you build credit.
However, there’s a catch. Most secured cards have lower limits, making it easy to have a high credit utilization ratio. With that, you’ll need to be very careful with how you use the card to avoid pushing your credit utilization ratio higher.
Get Credit for Alternative Payments
After a bankruptcy, it can be difficult to convince a lender to provide a loan. But other bill providers will still work with you.
Utilities, subscription streaming services, and a cellphone plan are some of the alternative payments that you could potentially add to your credit report. It’s possible to get credit for these payments when you work with the right services.
It’s possible to build credit with the help of a service like Experian Boost. The free service uses your bank records to determine your payment history for select bills. If it finds a positive payment history, that could positively impact your credit score. On average, Experian Boost users see their credit score increase by 13 points.
But the bills must be in your own name. So, if you split a streaming service like Netflix or Spotify with your cousin, you won’t get credit unless the account is in your name.
Try Credit Repair
If your credit report has inaccurate information, then credit repair is a worthwhile option.
In some cases, a mistake will drag your credit score down. After all, a misrecorded late payment doesn’t work in your favor. Credit repair can remove inaccurate negative information.
Depending on the volume of errors, you might decide to go it alone or work with a reputable credit repair service. You can file disputes with the credit bureaus yourself if you spot mistakes. But if you have dozens of errors on your report, then a service may help you navigate the situation efficiently.
The Bottom Line
After a bankruptcy, your credit score will likely suffer. But it’s possible to start rebuilding right away. Take action to give your credit score the boost it needs post-bankruptcy. Although it will take some time, it’s worth the effort.