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Which type of bankruptcy does the least credit damage?

Erica Sandberg

May 29, 2015

QHi Erica,

I could do Chapter 13 bankruptcy, but my lawyer said I will be better off with Chapter 7 if I want to have good credit. Why is Chapter 13 bankruptcy worse on my credit than Chapter 7 bankruptcy? Thank you. –Manuel

ADear Manuel,

The types of bankruptcies you mention are quite dissimilar, so they each impact a person's credit rating in different ways. To properly answer your question, I first need to cover what “good credit” is. Consumers don't make that determination, but rather, those who check credit reports and credit scores do.

Credit card issuers, finance companies, landlords and insurance firms, among others, assess their risk level in doing business with you by checking your credit reports or the scores that aggregate that data, or both. It's important to understand what they look for and how the different kinds of bankruptcy protection are generally perceived.Ask Erica

Most businesses rate payment pattern as most crucial, so paying on time is the weightiest factor in a FICO score, the most commonly used scoring model. Because Chapter 7 bankruptcy allows you to walk away from certain debt, having Chapter 7 on your credit reports would inform lenders that you had not honored at least some of what you owed.

A Chapter 13, on the other hand, is a repayment plan (over three to five years) that sometimes has a debt forgiveness component. You would be able to bundle various liabilities into one monthly payment made through the court, which then disburses it to those you owe. Companies that send information to the credit reporting agencies, such as credit card issuers, will report your payment activity. Eventually, the steady payments would result in a scoring uptick, especially if you were delinquent before.

Yet Chapter 13 is not always better than Chapter 7 for credit rating purposes. The reason: A Chapter 7 would allow you to immediately discharge substantial unsecured debts that might be driving your scores down. Credit utilization, which is how much you owe compared to how much you have available, is the second most important scoring category, so if you bring the balances to zero, you open up your credit availability — instant scoring points! With Chapter 13, you'd be stuck with a high credit utilization ratio until you paid the debt down.

Another advantage of Chapter 7 is that you might be able to quickly start adding positive activity to your credit reports again. If you were to get a loan or credit card (although that could be difficult to obtain initially), you could pay responsibly from that moment forward. That, plus no other consumer debt and the inability to file for bankruptcy again for another eight years, reduces lenders' risk. With Chapter 13, all you have is evidence that you're slowly but surely deleting your balances.

Chapter 7 is appropriate for people who genuinely cannot meet their financial obligations. If you have any property and money in the bank that can be claimed by the court to go to your creditors, you may lose it. The notation also stays on your credit report for a total of 10 years, as opposed to seven years for Chapter 13. A new credit issuer may not mind the Chapter 7 so much, especially as it ages, but a potential landlord or employer might; for them, Chapter 13 might look better. Also, you don't lose any property with Chapter 13 if you keep up the payments.

Which should you lean toward? I can't answer that without all the numbers and considerations, but a qualified bankruptcy counselor will. You can find one at specially certified nonprofit credit counseling agencies. Just don't let anyone push you into one or the other. This is your life, and the impact of filing any type of bankruptcy can be profound.

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