Definition

• Bankruptcy is a legal action that relieves you of some or all of your debts, and it often involves selling your assets, too. Chapter 7 is the most radical form, as the Federal Trade Commission explains that it involves selling most of your possessions and absolves you of most debts. Chapter 13 lets you keep assets and and requires some repayment. Both forms of bankruptcy appear on your credit reports, where they are considered very negative by lenders and credit scoring formulas.
  
  

Credit Score Effects

• Bankruptcy drops your credit score significantly. The exact impacts depends on your other credit-related activity, but the Electronic Privacy Information Center warns that you typically lose 120 to 220 points, which is often enough to keep you from opening new accounts or to subject you to penalty interest rates for being a high-risk borrower.
  
  

Prevention

• Filing for bankruptcy is sometimes preventable if you review your finances and create a tight budget to get things back on track. Get all your bills together and separate necessary items from things that can be cut out of your life, Dana Dratch of Bankrate advises. For example, your mortgage and utilities are essential, but you can replace a monthly gym membership with free forms of exercise like jogging or working out at home. Pay cash for your expenses while you pay down your credit-related bills. You salvage your credit score through paying down high balances and sending the money on time because the MyFICO scoring company identifies those as the two most important factors.
  
  

Considerations

• Bankruptcy may not hurt your credit as badly as you think if your finances were extremely bad before your filing. Your old debts get wiped away, so the bankruptcy itself is your main negative credit report entry. Credit scoring formulas compare you to other bankrupt consumers, according to Wall Street Journal Smart Money writer Aleksandra Todorova, so you are not competing with people who have high scores. Your score improves significantly if you handle your post-bankruptcy credit use responsibly. Charge only modest amounts and send in every payment before the due date.