Chapter 7 or 13 Bankruptcy Can Affect Credit Scores

Bankruptcy is often a painful decision. When many folks think about bankruptcy, they think about losing their personal effects. They wonder what it would be like to lose a car, say good-bye to a house, or put their family heirlooms up for sale.

However, bankruptcy can also lead to less tangible losses. Many people may need to dip into retirement accounts or savings that were intended to pay for a child's education. While these are all real-life consequences of a bankruptcy filing, bankruptcy does offer more protection than you might think.

That's fortunate, because bankruptcy filings continue to grow while the economy struggles to get back on its feet.

This year, more than half a million Americans filed for bankruptcy, typically citing unemployment or reduced income. Economists say this high rate could continue through the new year. A recent report by the American Bankruptcy Institute revealed that 65 percent of bankruptcy filers say income reduction was the main factor contributing to the bankruptcy, while 42 percent said the decision was the result of a job loss. (Unsurprisingly, many filers cited both reasons.)

Many filers reported strong financial histories, which were built upon spending within their means, making timely payments, and avoiding debt. Other filers, however, admitted to a more uneasy financial history. Interestingly, a recent SmartMoney article suggests that people who fall into the latter category may have an easier time filing for bankruptcy protection.

"Filers who have been conscientious borrowers and consumers will often have equity in their homes, possess cars that are partly or fully paid for, and hold savings accounts designed to provide for them in the future," SmartMoney reports. "But there's no credit for being responsible when it comes to bankruptcy court — and the more responsible a consumer has been, the more they have for a trustee to take and sell off to pay creditors."

Bankruptcy can also affect the credit scores of these two groups differently. People with a 780 FICO score could find their score drop 240 points after filing for bankruptcy, according to Consumer Affairs. But someone with a credit score of 680 would likely experience only a 150-point decrease.

Most people file for either Chapter 7 or Chapter 13 bankruptcy. Chapter 13 allows filers to hold on to the items they own but requires them to make enough money to cover expenses and pay creditors; payments are usually made over a three- to five-year period. Chapter 13 bankruptcies are less common than Chapter 7 filings.

Under a Chapter 7 filing, assets such as a car or home are given over as part of a payment plan. However, most debts are eventually forgiven.

Of course, different states have different rules regarding bankruptcies. Residents of Florida and Texas have exemptions that protect their homes during bankruptcy, Consumer Affairs says. Other states allow homeowners to retain their homes, provided they meet certain requirements.

Retirement funds can also be shielded from creditors. Accounts like IRAs are protected up to a little more than $1 million per person, Consumer Affairs reports. However, courts will likely view any last-minute, pre-filing contributions to such accounts skeptically.

Life insurance policies and college savings plans are also exempt in some instances. However, consumers looking to make the best decisions for their families are advised to examine the rules and regulations in their home states, since the exact rules may vary.