It’s never fun to consider declaring bankruptcy. But, believe it or not, bankruptcy can be a smart financial decision in certain situations. Bankruptcy’s designed to give people a fresh start when they need one. And if you file for bankruptcy, you’re taking a big step towards getting your finances under control. That’s always a responsible goal.
But it’s a serious decision with consequences. Your credit rating takes a big drop (as you may know already) and your spending habits may need to change. How do you know when the pros of bankruptcy outweigh the cons?
First, know the basics of what bankruptcy does. Bankruptcy usually does not eliminate all your debt. The courts treat different kinds of debts differently.
Here are the debts bankruptcy will NOT erase:
- Student loans, whether public or private. You can get relief from student loan payments, but that’s a separate process
- Income taxes you owe. There are payment options for back taxes. Just like student loans, though, income tax payments have a process all their own
- Child support and alimony
- Court fines or other legal penalties (such as traffic tickets)
- Debts to government agencies
- Debts for personal injury or death caused by drunk driving
- Any debts you forget to list in bankruptcy papers
Here are the debts bankruptcy CAN erase or make easier to pay over time:
- Credit card debt
- Car loans and lease obligations
- Medical debt
- Apartment and home lease obligations
- Utility bills
- Lawsuit judgments
- Personal loans
But debt itself doesn’t automatically make bankruptcy the best option. If any or all of the following circumstances apply to you, it might be time to file:
Creditors are suing you for unpaid debts
If creditors have already passed your debt to a collection agency, they may take the next step—a lawsuit. Debt collection lawsuits usually aren’t worth fighting in court. You’ll end up with court costs to worry about.
Bankruptcy will place an automatic “stay” on your account. This is a court order requiring creditors to cease all collection activity, including lawsuits.
Credit card debt is “unsecured” debt. This means creditors can’t repossess any items if you don’t pay it. Bankruptcy usually erases credit card and other unsecured debts.
If your utilities are about to be disconnected, bankruptcy can keep them from being cut off as well.
You’re facing home foreclosure and/or car repossession
Bankruptcy can issue a stay on any repossession or foreclosure activity, just like it can for credit card collections. But this stay’s a little more complicated.
Money you owe on homes and cars may be a “secured” debt, or a debt where a creditor can repossess the property. This is the case if a creditor has a lien on your home or car. A lien is basically a claim on your property saying the creditor can take it back if you don’t make payments. You may have to read the fine print or consult a professional if you’re not sure whether creditors have a lien on your home. Bankruptcy can erase what you owe—but it can’t keep creditors with liens from repossessing property.
Don’t panic! In many cases you can keep your home even after you file. One type of personal bankruptcy, Chapter 13 bankruptcy, gives you time to catch up on mortgage payments. The property you get to keep also depends on your state’s bankruptcy “exemption” laws—each state has different rules about which properties are exempt from creditor claims.
Your wages are being garnished
Wage garnishment, or creditors taking a certain percentage of your paycheck, may be the result of a lawsuit or court order. Bankruptcy’s automatic stay will stop the garnishment.
You pay for everything on credit cards
If you’re paying off debt by digging yourself deeper into debt, bankruptcy can help you break the cycle. Chapter 7 bankruptcy, the most common type of individual bankruptcy, usually erases credit card debt.
You’re dipping into a retirement account to pay bills
Thought it may be tempting, think twice before you turn to retirement funds. Most states protect your pensions, life insurance, and retirement accounts like IRAs and 401(k)s in bankruptcy. You can file, get the rest of your bills under control, and keep the retirement funds. Check the specific legislation in your state to find out what’s protected.
Paying off your debts will take five years or more
To get a full financial picture, calculate how much you owe, to whom, and when you think you can repay—or how long you can manage modest regular payments without going underwater. Focus on the debts bankruptcy can possibly discharge, like credit card debt.
If you don’t see yourself making a dent within five years, much less paying everything back, bankruptcy may give you much-needed relief.
Your revolving debt exceeds your annual income
Revolving debt is any debt with an open-ended term or no end date. Credit cards, personal lines of credit, and home equity lines of credit are all sources of revolving debt. The debt “revolves” from month to month, though you pay a percentage each month.
You’ve tried everything else
Maybe you’ve already negotiated with creditors for a better payment plan. You’ve refinanced loans. You’ve done your best to budget and search for more income sources. And you’ve explored debt consolidation, management, and settlement.
Been there, done all of the above? Keep reading.
Since declaring bankruptcy takes time and affects your credit, it’s often considered a last resort. But the resort is there for a reason. Life happens. Overwhelming medical debt, for example, is a frequent cause of bankruptcy. If medical bills are stressing you out, though, you may have more options than you realize.
You’re eligible to file
We’ll discuss the two types of individual bankruptcy—Chapter 7 and Chapter 13—in detail below. But first, find out if you qualify.
For either type of bankruptcy you should be 90 days overdue on all the debts you need to discharge.
Chapter 7 bankruptcy requires filers’ monthly income to be below the median monthly income for their state (and a household of their size). To figure out your median income, add your gross income from the past six months and divide by six. Then deduct “reasonable and allowable expenses”. This includes what you spend each month on essentials like groceries, housing, and transportation. The number remaining is the income you have available to repay debts.
Here’s a 2016 estimate of the median annual household incomes per state—divide this number by 12 to see if you’re below the average.
If your income’s over the limit, you might still qualify for Chapter 13 bankruptcy.
So how are the two types different? And which one should you choose?
Chapter 7 bankruptcy
Otherwise known as “liquidation bankruptcy,” Chapter 7 is designed for individuals with no way to pay their bills otherwise. This type of bankruptcy pays off as much of your unsecured debt as possible, including credit card debt and medical bills. The court “liquidates” your assets by converting them into cash to pay off your creditors.
The process takes anywhere from three to six months. It’s usually much quicker than Chapter 13 bankruptcy. You can keep any assets your state marks as “exempt.” Your house or car, for instance, may or may not be exempt depending on the state you live in. If they’re not exempt, they can be collected. You’re more likely to lose assets if their equity—the value of the property minus the amount still owed—is high.
What if you have little to no income and few (if any) assets? Chapter 7 bankruptcy may be the best choice for you. Be aware, though, Chapter 7 doesn’t erase the obligations of any co-signers you may have on a loan.
Chapter 13 bankruptcy
Also known as “reorganization bankruptcy” or “wage earner’s bankruptcy,” Chapter 13 is designed for people who have a consistent income and who want to keep their property. Chapter 13 bankruptcy gives filers a “grace period” of between three to five years to make payments on their debts. Any debts that remain at the end of the grace period are discharged.
The Chapter 13 plan is similar to debt consolidation. Unlike Chapter 7, this plan lets you keep your assets. It can erase the same debts Chapter 7 can erase, along with any debts from a divorce (except for alimony and child support). The court will determine the value of your equity in assets, look at your income and expenses, and figure out a repayment amount and schedule.
If you have money coming in but you need to buy some time—and you want to ensure you keep your house—Chapter 13 bankruptcy may be the best choice for you. Chapter 13 also protects any co-signers, as long as you make payments on time.
What to know before you file
This is not a decision to be taken lightly (obviously), so consider the following before filing.
Your credit will be affected
A Chapter 7 bankruptcy stays on your credit report for 10 years. A Chapter 13 bankruptcy stays on your credit report for seven years. Scores can drop anywhere from 50 to 200 points (higher scores will drop more steeply). You may have trouble getting certain loans or will pay higher interest rates. But people have successfully obtained credit and even purchased homes after declaring bankruptcy. Good money management practices, from here on out, go a long way.
You’ll have a meeting or two in court
For Chapter 7 bankruptcy you only have to go once, to a hearing called a “Meeting of Creditors.” The trustee will ask you questions about the paperwork you filed, including your assets and debts. Creditors may or may not attend—they usually don’t. For Chapter 13 bankruptcy you go to court twice, for the Meeting of Creditors and an additional confirmation hearing.
You need a lawyer
Technically you can represent yourself, but experts don’t recommend doing this. Filing becomes complicated and takes time and research to get all the facts right. Especially with a Chapter 13 bankruptcy, the more complex kind, there are details of bankruptcy law only an attorney can navigate. Fees range between $2,000 and $4,000. The fee may seem steep, but you’ll save on the penalties you might pay otherwise. The American Bar has a directory of bankruptcy lawyers. Some lawyers offer free first consultations, and you may even be eligible for pro bono representation. The American Bankruptcy Institute keeps a list of pro bono bankruptcy attorneys in each state.
Bankruptcy becomes part of a public record
Potential lenders will know you’ve filed for bankruptcy in the past. Your employer, however, can’t fire you for declaring bankruptcy.
There’s a fee of around $300 to file
If your household income is less than 150% of the poverty line, the fee can be waived.
You’ll have mandatory financial counseling
The process of filing for bankruptcy includes mandatory lessons on financial literacy. You take one class before you file and one class before your bankruptcy is discharged.
Your spouse won’t be affected
Your spouse does not have to file for bankruptcy, and your filing won’t affect their credit. The exception is if you need relief from debts you acquired together. In that case you can jointly file for bankruptcy.
You’ll need to simultaneously stop bill payments
Once you file you’ll probably be required to stop all bill payments at once. This may feel strange, but any payment can show you favor one creditor over another, which creditors don’t like.
Filing bankruptcy, first steps
If you think you may be a candidate for bankruptcy, start gathering as much information as you can as early as possible. Although you can learn a lot online about the pros and cons of bankruptcy—and what to expect if you file—you’ll want a lawyer that specializes in bankruptcy to actually go through with filing.
Bankruptcy filing fees and your lawyer’s fees are apt to cost anywhere from $1,000 to several thousand dollars, which is another reason why the decision to file bankruptcy should be made extremely carefully.
If, however, creditors are already pursuing you in court, and bankruptcy will help keep the roof over your head and food on the table, those costs—and the other downfalls to bankruptcy—may just be worth it.
Filing for bankruptcy is a last resort and can be frustrating. But the end result should give you a little breathing room and a chance to rebuild your finances. Take advantage of this chance if you need to.