Editorial Policy

Bankruptcy Choices: Chapter 7, or Chapter 13?

Erica Sandberg

January 12, 2012

QHi Erica,

What is the difference between Chapter 7 and 13 when it comes to the impact on your credit history? I don’t want to get another credit card, but fear that, if I do not have one to deal with an emergency, I could be in trouble. I hated to file bankruptcy, but, even with two jobs, I was drowning. So I ended up with a Chapter 13. I’m looking at retirement in 10 years. Will I have to wait that long for an improved credit rating? — Dan

ADear Dan,

I’m glad you wrote, not only because I want to clear up your confusion, but also because bankruptcy is a fascinating subject. For instance, do you know that, when America was formed, it’s estimated that nearly two out of every three entering Europeans owed money in their native lands? They weren’t just fleeing religious and political oppression, but were running from their creditors.

Bankruptcy protection plays a valuable role both in the economy at large and for the individual. While I firmly believe that borrowers should make every effort to repay their lenders, there are circumstances that make bankruptcy the best solution for certain financial problems. Your situation is a perfect example. But which one is better — Chapter 7 or 13? They are quite different, and each has positive and negative qualities. The first, as you noted, is the impact it has on one’s credit rating.Ask Erica

With a Chapter 7, you would be absolved of most unsecured debts, such as those acquired on the credit cards. The credit effect is harsh, though, as the notation will appear on your credit report for a total of 10 years, and, unless it was already at the bottom, your score will decrease dramatically when you file.

On the other hand, Chapter 13, which is a court-supervised repayment program, can appear a little better on a report to someone viewing it. The reason is that, instead of totally walking away from your debts, you’re working on paying at least some of them down. But while the notation will appear on your report for seven years, the effect on a FICO score is identical to that of a Chapter 7. This may sound ridiculous, but the company’s research has found that they are equally as predictive of future creditworthiness.

It sounds like you’ve decided on Chapter 13, which makes sense. You’re employed, so you have the ability to pay at least a portion of your obligations, and you seem to genuinely want to do the right thing and take control of your financial life.

So should you add a new credit card to your wallet? Perhaps. They can be great tools, though I would avoid using them for emergencies. That’s what savings and insurance are for.

The other question, however, is whether you can get a card with the bankruptcy notation dragging your scores down. The answer is “maybe.” The trustees who are managing your Chapter 13 must first grant permission. If they do, you’ll need to find an issuer that will lend to you again. That shouldn’t be too difficult, actually. After a couple of years — not a decade — the bankruptcy’s derogatory impact will wane, and many credit card companies offer cards for people with bad credit.

In the meantime, I recommend that you complete the repayment program as fast as you can, and then move on to saving aggressively for unexpected expenses and retirement. If you choose to get another card, charge a few necessary expenses per month, and pay the balance in full and on time. This way, you’ll be offsetting old damage with fresh, healthy credit use — and preventing yourself from ending up back in bankruptcy court.