Everyone knows that filing bankruptcy will have a negative affect on your credit report, but how long does that last? How bad is it?

There is no one simple answer to this question.  Filing bankruptcy effects everyone differently since each credit file is unique. In some cases the credit is already so bad that there is nowhere to go but up.  In other cases where the credit score is very high but filing bankruptcy is necessary when jobs are lost, the credit score will take a big hit. Here are some general rules.

Chapter 7 says on a credit report for 10 years.  

Does that mean you cannot get credit for 10 years?  No, it means that when you apply for credit the bank will see that you filed bankruptcy within the last 10 years.

Chapter 13 says on a credit report for 7 years.

A chapter 13 case remains on the credit report for 7 years after the case is completed.  Chapter 13 cases are completed in 3 to 5 years.  So, chapter 13 will be reported for 10 to 12 years, depending on the length of your case.

Most credit scores are higher one year after filing bankruptcy.

This seems really odd, but in most cases a credit score is higher a year after the case is completed if a debtor makes timely payments on the debts they retain, such as car and mortgage debts. We commonly think that filing bankruptcy will hurt a credit score, but that is not the case.  Why?  consider these factors:

  • Debt-to-Income Ratio.  Approximately one-third of your credit score is based on your debt-to-income ratio.  For example, if you earn $40,000 per year and you owe $40,000 of credit card debt, your ratio is one-to-one.  That’s a high ratio and it looks bad.  However, if you owe $10,000 on credit cards the ratio is one-to-four, and that is much better. The lower the ratio the better. So, guess what bankruptcy does to that ratio?  Right, filing bankruptcy dramatically lowers your debt to income ratio, and that actually helps your credit score.
  • Payment History.  Credit scores are based on your overall payment history.  This is where filing bankruptcy has a mixed result.  The bankruptcy filing itself is negative, but since you are relieved of paying unwanted debts and garnishments are stopped, you are better able to pay future auto and mortgage debts on time. So, after bankruptcy most debtors immediately start building better payment histories.

Will you be able to get credit after filing bankruptcy?

Yes, you can get credit immediately after the bankruptcy is completed.  The more important question is what kind of credit will you receive.  At first the interest rates are high.  But over time as you establish better payment histories the credit terms improve.  You will be able to apply for FHA mortgage loans two years after the bankruptcy is completed, and most auto lenders will make loans immediately after the case is discharged.

Do I need to apply for credit cards to rebuild my credit after bankruptcy?

There is generally no need to apply for new credit after bankruptcy to rebuild credit. Rather, most debtors will reaffirm their auto or mortgage debts during bankruptcy, so these debts will survive bankruptcy and will provide all the post-bankruptcy credit reporting you need.  Student loans also survive bankruptcy and you will receive positive credit reporting from these debts if payments are made on time.  If you exit bankruptcy with absolutely no debt at all, then it may make sense to apply for a small credit line, but make sure you pay the balance in full each month.

My general concern is not whether you will receive credit after filing bankruptcy.  Rather, my concern is that you will obtain too much credit and wind up in the same spot again.  We live in a credit society, and the ability to borrow will always be there. In fact, some creditors will send new credit card offers before the bankruptcy is over!

Two great places to learn about credit is at www.MyFico.com and Bankrate.com.  When we talk about a credit score, we are generally referring to your FICO score.  Most of it is common sense.  Keep your loan balances low.  Pay credit on time, never late.  Don’t max out your credit lines. Reduce your total debt levels over time to achieve a lower debt-to-income ratio.  Try not to carry credit card balances.  Keep auto loan balances low.

In the short-term filing bankruptcy is a bad mark on credit, but if you learn from your mistakes and establish good credit habits, you will be able to establish credit after bankruptcy.

Image courtesy of Flickr and Mark Moz