Understanding The Impact of Bankruptcy on Your Credit Score
Many consumers overwhelmed by debt often wonder, "how does filing for bankruptcy affect my credit score?" This is a critical concern since a credit score plays a crucial role in the path to achieving major life milestones, such as buying a house, securing a loan, or even landing a job. Understanding the relationship between bankruptcy and your credit score will not only help you make informed financial decisions but also aid in devising a plan to recover and rebuild.
The ABCs of Credit Scores
A credit score is a three-digit number derived from your credit history. It is essentially a numerical summary that lenders use to gauge your creditworthiness. The most common type of credit score is the FICO score, which ranges from 300-850. Higher scores indicate lower credit risk, and vice versa. Scores are calculated using data from your credit reports and include payment history, outstanding debts, length of credit history, new credit applications, and the mix of credit types you have.
Bankruptcy: An Overview
Bankruptcy is a legal process that allows people or businesses unable to repay their debts to get a fresh start. According to the U.S. Federal Courts, bankruptcy can eliminate most or all a person’s unsecured debt. There are two common types of personal bankruptcy: Chapter 7 and Chapter 13.
Chapter 7, also known as “liquidation” or “straight” bankruptcy, discharges most of the debtor's unsecured debt (e.g., credit cards, medical bills), but they may have to sell some of their property to repay creditors. Meanwhile, Chapter 13, or “reorganization” bankruptcy, enables people with regular income to create a plan to repay all or part of their debts over three to five years, without having to sell their property.
The Impact of Bankruptcy on Your Credit Score
Filing for bankruptcy will undoubtedly impact your credit score. However, the extent of the damage primarily depends on your credit score before filing. If you initially had a high credit score, filing for bankruptcy would cause a more significant drop compared to someone with a lower score to begin with.
For instance, according to FICO, a person with a credit score of 780 who files for bankruptcy will lose between 220 and 240 points, whereas someone with a score of 680 will lose 130-150 points. On average, a Chapter 7 bankruptcy will cause your credit score to drop by 160 points, and a Chapter 13 bankruptcy will lower it by 130 points.
The Duration of Bankruptcy on Your Credit Report
The bankruptcy notation will remain on your credit report for a significant period. Under the Fair Credit Reporting Act, Chapter 7 bankruptcies can stay on your report for up to 10 years from the filing date, while Chapter 13 bankruptcies can remain for seven years or 10 years, depending on whether you completed the repayment plan or not.
During this time, the mark may make it challenging to open new credit accounts since lenders may be wary of your history and consider you a high-risk borrower. If you do manage to get new credit, it's likely at a much higher interest rate.
Rebuilding Credit After Bankruptcy
While the impact of bankruptcy on your credit score might seem severe, it's essential to remember that it's not a financial death sentence. There are steps you can take to start rebuilding your credit post-bankruptcy.
The first step to recovery is ensuring that your credit report accurately reflects all information. You must also create a strict budget to avoid falling back into a hole of debt. This helps you live within your means and save money for emergencies.
Another essential step is to start building a positive credit history. You can do this by paying all your bills on time, applying for a secured credit card, getting a credit-builder loan, or being added as an authorized user on someone else's card. Always maintain a low credit balance and regularly check your progress by reviewing your credit score.
Furthermore, financial counseling and education can help understand the root causes of your financial difficulties and guide you towards better management of your finances.
Bankruptcy as a Last Resort
Taking the leap and filing for bankruptcy should always be considered a last resort. It’s always recommended to explore all other available options first, such as debt counseling, negotiation with lenders, debt consolidation, or sale of assets.
Wrapping Up: A New Financial Chapter
Without a doubt, bankruptcy can damage your credit score significantly. Additionally, it leaves a long-lasting mark on your credit report that could affect your future borrowing abilities. However, this shouldn't discourage you since rebuilding credit after bankruptcy is attainable with discipline and guidance. Ultimately, understanding how bankruptcy affects your credit score and taking corrective measures can put you back on the path towards a healthier financial future.
