Struggling with debt and wondering if filing for bankruptcy is a solution? It’s vital to separate myth from fact when it comes to knowing what it means for your personal finances and how it may affect your credit score.

Bankruptcy is usually a step of last resort, and there are a number of alternatives you can consider. Will bankruptcy always have a negative impact on your credit score? Yes, but the impact will vary — and lessen with time and positive credit behavior.

What is bankruptcy?

Bankruptcy is a legal, court-supervised process that can help relieve or reorganize an unmanageable debt burden for those in financial difficulty. All bankruptcy cases are handled in federal courts, and there are different types of bankruptcy that individuals can file.

Types of personal bankruptcy

Named for the chapter of the U.S. Bankruptcy Code that describes them, the two primary types of personal bankruptcy used by individuals are Chapter 7 and Chapter 13. Each has rules that may treat assets, debt and property differently — and therefore may apply to certain financial situations better than others.

How does bankruptcy work?

A basic goal of bankruptcy law is to give debtors a fresh financial start. Some types of debt are forgiven, or discharged or restructured. This may include things like credit card balances, medical debt, overdue rent, personal loans and utility bills. Declaring bankruptcy prohibits creditors from taking action against you to collect those debts — such as seizing collateral, garnishing wages, launching collections or filing lawsuits. But other types of debt outlast the bankruptcy filing. And the type of bankruptcy filing you choose will handle the process and resolve debts differently. Here’s how it works.

Chapter 7

Think of Chapter 7 bankruptcy as a total liquidation. The process will use existing assets — including selling them and using the proceeds — to repay creditors and clear existing debts simultaneously.

Chapter 13

Think of Chapter 13 bankruptcy as a reorganization, or debt adjustment. This type of filing creates a mutually agreeable plan to repay a portion of debts to creditors over time — typically over three to five years. In exchange for this schedule of repayments, the bankruptcy court allows you to keep some assets — such as a home.

How does bankruptcy affect your credit?

Bankruptcy can give you a fresh start, but it will stay on your credit reports at the major credit bureaus for years and negatively affect how future lenders may view you as a potential borrower. Bankruptcy is a matter of public record, so any lenders you apply to for new credit will see it listed on your credit report. That means they can consider that information in their lending and credit risk decisions. Keep in mind, however, that bankruptcy removes or reduces current debt burdens — and that outcome will likely improve your ability to manage future finances and repay new debts.

How long does bankruptcy appear on a credit report?

A Chapter 7 filing will stay on your credit report for 10 years from the filing date, while a Chapter 13 will remain for seven years. As with most negative credit events, the longer it’s been since the bankruptcy, however, the less impact it will have on your credit score.

What types of debt are not cleared by bankruptcy?

There are certain debts that don’t get erased in bankruptcy and some that can be discharged only in rare cases. Here are the most common types of debt that aren’t usually cleared:

  • Alimony and child support. These obligations get special protection under bankruptcy law and are considered non-dischargeable debts that will continue to be owed.
  • Court fees.
  • Taxes, such as tax liens and income tax (but payment alternatives may be available directly through the IRS).
  • Student loans. Usually, for student loans to be discharged in bankruptcy, you have to prove that the payments would cause an “undue hardship” to you or your dependents. In some cases, a court may discharge part, but not all, of student loan debt. Regardless, there may be payment plans directly available to you with federal student loans and your loan servicer.
  • Unlisted debts — meaning any debts you missed or failed to list in your bankruptcy filing.

Can your credit score recover from bankruptcy?

A credit score won’t rebound overnight post-bankruptcy, but once the legal process is completed, your credit report will show that both the bankruptcy and the debts included in it were discharged. The actual impact of the bankruptcy on your credit score after the fact varies based on the time since the bankruptcy and your credit behavior since. But in general, and with all other things being equal, a credit report with a bankruptcy will likely have a credit score 50 points to 100 points lower than one that doesn’t.

How and when it can rebound

It's important to remember that a credit score predicts the chances of any debt defaulting in the next two years. By adding new, positive information to your credit report after a bankruptcy ends, you can rebuild your credit score by prioritizing factors that influence it the most:

  • Committing to an on-time payment streak.
  • Keeping credit utilization in check.
  • Paying off any remaining debt.
  • Limiting new debt.

In fact, it’s quite possible to have good credit in 12 to 18 months after a bankruptcy.

What are the alternatives to bankruptcy?

Bankruptcy is not always the best — nor only — option for everyone. So, it’s important to thoroughly weigh alternatives that may have less of an impact on your credit rating. Here are a few to consider.

Debt consolidation

Debt consolidation merges multiple debts into one loan with one monthly payment — often at a lower interest rate. This debt solution not only can help you save money on interest, but it can also lower monthly payments, allow you to make fewer monthly payments and potentially pay down debt faster. Many financial institutions and other lenders offer this type of loan, and approval is based mainly on your credit score and ability to repay.

Debt management plan

A debt management plan is a type of debt repayment plan that’s set up and managed by a consumer credit counseling agency — for a fee. The counselor tries to secure better terms with your creditors — like waiving late payments fees or trimming high interest rates on outstanding balances. The plan typically aims to pay off debts within three to five years; and it only handles unsecured debts, like personal loans or credit cards, vs. secured debts, like car loans or mortgages. As part of the deal, you likely won’t be able to apply for new credit card offers or other loans during the term of the plan.

Debt settlement

Debt settlement is a fee-for-service program that negotiates debt forgiveness on your behalf. In a lump sum settlement, the debt settlement company makes one large payment to the creditor. In a term settlement, multiple payments are made to settle the debt over time. There’s no guarantee that creditors will accept less than what’s owed, however. And debt settlement first requires you to avoid paying debts, making them delinquent. Delinquencies appear on your credit report and can hurt your credit score. Because of the risk involved, the nonprofit National Foundation for Credit Counseling doesn’t recommend debt settlement as a solution.

Understanding the risks and rewards of bankruptcy

Bankruptcy is a last-resort option that can eliminate many types of debt and give people a fresh start to their financial life. It doesn’t wipe out every obligation, however, and it will negatively affect credit scores for a period of years. While filing bankruptcy removes current debt burdens — which could strengthen future finances — there also are alternative options that may help achieve a similar debt relief outcome, without the lasting effects.