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Understanding Bankruptcy and Rebuilding Your Credit

Bankruptcy can shield you from financial ruin when debts become insurmountable, but it has severe, long-lasting negative impacts on your credit and is best considered a last-resort option. In this article, we will explore how bankruptcy works, why it is often viewed negatively, and how you can rebuild your credit after filing for bankruptcy.

How Does Bankruptcy Work?

Bankruptcy protects individuals who can’t pay their debts from losing everything to creditors. In the U.S., bankruptcy is overseen by special federal courts and often provides a framework by which you can 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 with its own specific qualifying criteria required by the courts.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy, also known as a liquidation bankruptcy, is available to individuals whose income is too low to cover their outstanding debts. It erases many debts altogether but may require you to forfeit assets worth more than a basic exempt amount. Forfeited assets are sold by a court-appointed trustee, and proceeds are divided among your creditors. Chapter 7 bankruptcy is often finalized within four to six months after you file.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy, sometimes called a wage-earner’s plan, is designed for those with enough income to afford at least partial repayment of their debts. It allows you to retain more property than Chapter 7 and sets up a three- to five-year repayment plan, after which time your remaining debts are forgiven. Chapter 13 may not repay all your debts in full, but they allow creditors to recoup more of what they are owed than is often possible in a Chapter 7 bankruptcy.

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. But at the conclusion of each bankruptcy proceeding, assuming you have fulfilled all the court’s requirements, most other forms of debt are considered discharged: You are no longer responsible for them, and your creditors are forbidden from trying to collect them.

Why Is Bankruptcy So Bad?

The negative consequences of bankruptcy are numerous:

You Can Lose Your 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—but it may not ultimately prevent them from seizing those assets, which serve as collateral on secured debt. A Chapter 13 repayment plan can help you get caught up on missed payments so you keep your car and/or home. Chapter 7 can free you of responsibility for the payments you missed but may not stop creditors from seizing the collateral that secured their loans if you don’t make your payments, reaffirm the debt during bankruptcy, or redeem the property.

You’ll Pay Filing and Attorney Fees

Filing a Chapter 7 or Chapter 13 bankruptcy petition requires paying a court administration fee (set at $78 for 2024), and the bankruptcy process may entail additional court-imposed fees related to specific procedures, document certifications, and other administrative costs.

Hiring a bankruptcy attorney is advisable (but not obligatory), and while fees vary by jurisdiction, bankruptcy courts work to ensure they are kept reasonable. If you file Chapter 7, you’ll need to pay your lawyer up front. If you file Chapter 13, which typically involves higher legal fees, you can factor your lawyer’s bills into your repayment plan.

Your Credit Score Will Likely Suffer

Bankruptcy is recorded on your credit reports and remains there for seven years from the filing date for Chapter 13, or 10 years from the filing date for Chapter 7. A bankruptcy on your credit reports has a deep, long-lasting negative impact on your credit scores. The number of points your scores fall will depend in part on what your scores were before filing bankruptcy, and whether missed payments and other negative credit report entries lowered your scores significantly prior to your bankruptcy filing.

You May Have a Hard Time Getting New Credit

Some lenders decline credit or loan applications from any borrower with a bankruptcy on their credit report. Other lenders, such as those focused on subprime borrowers, may accept applications after a bankruptcy is several years old, but they typically charge steep 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, but you can begin rebuilding your credit as soon as your bankruptcy is discharged, using proven measures such as these:

Get a Secured Credit Card

To get a secured credit card, you put down a cash deposit that serves as some or all of your borrowing limit. If you fail to pay your bills, the lender keeps the deposit. You use the card as you would any other credit card. Doing so regularly and taking care to make your monthly payments on time and ideally in full, you can establish a history of positive payments on your credit reports and the lender may convert you to an unsecured credit card.

Take Out a Credit-Builder Loan

Credit-builder loans are specifically designed to help establish or rebuild credit, and to help you save a little money: The amount you borrow—usually $1,000 or less—is placed in a savings account you cannot access until the loan is paid in full. Making monthly installment payments on time over a term of six to 24 months adds positive payment information to your credit reports, and when you complete the payments, the funds are yours, sometimes with interest.

Become an Authorized User

Consider asking a friend or family member with good credit to add you as an authorized user on one of their credit card accounts. Doing so will add the full history of the account to your credit reports, which can have an immediate positive impact on your credit score. When you become an authorized user, the primary account holder can opt to give you a card linked to the account, which you can use to make purchases. If they do, avoid excessive charges and be sure to arrange for payment of charges.

Seek a Cosigner

To improve your odds of getting approved for a loan with favorable terms, consider asking a loved one with good credit to cosign your loan application. If you’re approved, you’ll be responsible for making payments, but your cosigner essentially agrees to step in and pay off the loan if you can’t or don’t. As a result, lenders that allow cosigners will consider both credit histories and income profiles to determine your eligibility, interest rate, and other credit terms.

Try Experian Boost®

If you don’t have many credit accounts after a bankruptcy, getting recognized for on-time payment of your utility, cellphone, and other bills can help you build your score. Experian Boost can add eligible payments to your Experian credit report and give your scores a lift, instantly.

The Bottom Line

Bankruptcy can bring relief from the stress of insurmountable debt, but it has severe negative consequences for your credit. Bankruptcy can limit or block your ability to borrow money and may even lead to loss of property, but its effects will fade over time. You can 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 are looking for expert mortgage services to help you navigate your financial future, contact O1ne Mortgage at 213-732-3074. Our team of professionals is here to assist you with all your mortgage needs.

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