Truth & Character Thursdays

“I spend my life constantly calling in ‘imaginary’ debts that aren’t owed to me in order to avoid the ‘real’ debts that I owe to others, and so everybody ends up bankrupt.” ― Craig D. Lounsbrough

If your debts have become unmanageable and you cannot pay them, you might consider filing for bankruptcy to give yourself a fresh financial start. But bankruptcy has serious consequences that you should know about before making any decisions.

For example, bankruptcy will remain on your credit report for seven or 10 years, depending on the type of bankruptcy. That can make it difficult to obtain a credit card, car loan, or mortgage in the future.1

Here’s what happens when you file for bankruptcy, along with some alternatives that you might want to consider first.

KEY TAKEAWAYS

• Bankruptcy is a legal process for getting relief from debts that you cannot repay.
• If you file for personal bankruptcy, you generally have two options: Chapter 7 or Chapter 13.
• A Chapter 7 bankruptcy will sell off many of your assets to pay your creditors.
• In a Chapter 13 bankruptcy, you keep the assets but must repay your debts over a specified period.
• Bankruptcy can do severe damage to your credit score and should be considered a last resort.
• As an alternative, you may be able to negotiate with your creditors and work out a payment plan or other solution.

What to Do Before You File for Bankruptcy

Bankruptcy is generally considered a last resort for people who are deep in debt and see no way to pay their bills. Before filing for bankruptcy, however, it’s worth considering some alternatives. They are less costly than bankruptcy and likely to do less damage to your credit record.

For example, your creditors may be willing to negotiate. Rather than wait for a bankruptcy settlement—and risk getting nothing at all—some creditors will agree to accept reduced payments over a longer period of time.

In the case of a home mortgage, call your loan servicer to see what options may be available to you. Some lenders offer alternatives such as:

• Forbearance. This could allow you to postpone payments for a period of time.
• Repayment plans. A repayment plan might result in smaller payments stretched over a longer period.
• Loan modification. The lender may also agree to change the terms of your loan, such as lowering your interest rate for the remainder of the loan.

Even the Internal Revenue Service (IRS) is often willing to negotiate. If you owe taxes, you may be eligible for an offer in compromise, in which the IRS agrees to accept a lower amount. The IRS also offers payment plans, allowing eligible taxpayers to pay what they owe over time.

For guidance on options for your specific situation, you can seek help from a financial counselor. Many states have offices of financial counseling or debt relief that help residents for free or for a low fee.

Types of Personal Bankruptcy

If you decide to proceed with personal bankruptcy, you will have two types to choose from: Chapter 7 or Chapter 13. They differ primarily in what happens to your assets and how your debts are discharged.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy essentially liquidates your assets to pay your creditors. Some assets are exempt, so you get to keep them. Exempt assets usually include:2

• Part of the equity in your home and automobile
• Personal items
• Clothing
• Tools needed for your employment
• Pensions
• Social Security
• Any other public benefits2

Your remaining, nonexempt assets will be sold off by a trustee appointed by the bankruptcy court. The proceeds will then be distributed to your creditors. Nonexempt assets may include:

• Property (other than your primary residence)
• Recreational vehicles
• Boats
• A second car or truck
• Collectibles or other valuable items
• Bank accounts
• Investment accounts

At the end of the process, most of your debts will be discharged and you will no longer be under any obligation to repay them. However, certain debts, like student loans, child support, and taxes, cannot be discharged. Chapter 7 is generally chosen by individuals with lower incomes and few assets. Your eligibility for it is also subject to a means test.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy allows you to retain your assets, but you must agree to a plan to repay your debts over a period of three to five years. The trustee collects your payments and distributes them to your creditors. Chapter 13 bankruptcy is normally chosen by people who want to keep their nonexempt property intact or buy time against foreclosures or property seizures.3

Means Test for Chapter 7

Whether to file for Chapter 7 or Chapter 13 is not your decision alone. The courts also impose a means test to determine whether you are eligible for Chapter 7.

The means test starts by comparing your average income over the previous six months with the median income for a household of your size in your state. If you earn less than the median, you should be eligible for Chapter 7.

Even if your income is higher than the median, you may be eligible after subtracting certain allowable expenses. But if the calculation shows that you would have enough disposable income left over to begin repaying your debts—rather than having the slate simply wiped clean—the court may decide that Chapter 13 is your only option. To help determine your eligibility, you will be required to fill out a Form 122A-2.4

Image by Julie Bang © Investopedia 2020

Steps in Filing for Bankruptcy

Filing for and going through bankruptcy can be a long process with multiple steps. Knowing what is involved ahead of time can help you prepare.

Consulting an Attorney

If you’ve decided to file for bankruptcy, your first step should be to consult an attorney. While it is possible to file without one, a qualified attorney is often important because bankruptcy has long-term financial and legal consequences. Your attorney can advise you on which type of bankruptcy is appropriate in your situation.5

Attending Counseling

Before you file, you’ll be required to attend a counseling session with a credit counseling organization approved by the U.S. Department of Justice’s U.S. Trustee Program. The counselor should evaluate your personal financial situation, describe the alternatives to bankruptcy, and help you devise a budget plan.

Counseling is free if you can’t afford to pay. Otherwise, it should cost about $50, according to the Justice Department.6

Bankruptcy is governed by federal law, and cases are handled by federal bankruptcy courts, although some rules differ from state to state.

Listing Your Debts

You will be asked to supply the court with a list of all the money you owe. Your debts fall into two categories:

• Secured debts include loans in which the creditor has a security interest in property that was provided as collateral when you took out the loan. Mortgages and car loans are the most common types of secured loans—the collateral being your home or your car, respectively.
• Unsecured debts are not backed by property or other collateral. Examples include credit card debt, medical bills, and unsecured personal loans.

The bankruptcy court considers secured debt to be higher priority because failing to pay it can allow the creditor to lay claim to the property serving as collateral.

Once all the essential information has been filed with the court, the court appoints a trustee, whose job is to make sure that your secured debt is repaid over a given period. At that point, the court issues an automatic stay that prevents creditors from seizing the assets through property confiscation or foreclosure.

Discharging Your Debts

When the bankruptcy court issues a discharge, you are relieved of your liability to pay back the listed debts. That means creditors no longer have a legal claim against the debts, so they cannot pursue any collection activity, take any legal action, or even communicate with you.

The court will send your creditors a notice that the debts have been discharged. A copy will also be sent to your lawyer and to the U.S. Trustee Program at the Department of Justice. Any creditor who attempts to collect a debt after receiving a notice of discharge can be fined.

For a Chapter 7 bankruptcy, the discharge is usually issued anywhere from four to six months after the bankruptcy petition is filed. The discharge under Chapter 13 bankruptcy is issued after the payment plan is complete, usually three to five years after the bankruptcy filing.7 

Once your debts have been discharged by the court, those creditors can no longer attempt to collect them or take other legal action against you.

Rebuilding Your Credit After Bankruptcy

Bankruptcy will remain on your credit report for up to seven years (in the case of Chapter 13) or 10 years (in the case of Chapter 7). That can make it difficult to obtain further credit, such as a bank loan or a conventional credit card.

However, the effect of bankruptcy on your credit score will diminish over time, and your score will gradually improve if you show that you’re using credit responsibly.1

One tool for doing that is a secured credit card, where you make a deposit with the issuing bank, which then becomes your credit limit. By using that card judiciously and making your payments on time, you can begin to establish a fresh credit history. After a period of on-time payments, you may become eligible for a regular, unsecured credit card.

The process of rebuilding your credit and restoring your financial life can take time. But bankruptcy—if you have no other viable choice—can help you start fresh.

Is it a good idea to declare bankruptcy?

Bankruptcy is not an easy fix for being in debt. It can result in your losing a great deal of your personal assets to repay what you owe, as well as negatively affecting your credit score for up to a decade. In some cases, though, it may be the best or only option you have for paying off your debts and rebuilding your financial life.

Does declaring bankruptcy get rid of all your debts?

Some debts cannot be eliminated by declaring bankruptcy. These include child or spousal support, student loans, damages from drunken driving, criminal fines, and most unpaid taxes.23

How much debt do I need to file for bankruptcy?

There is no minimum level of debt needed to file for bankruptcy. However, given the impact it can have on your property, credit, and overall financial life, you should generally file for bankruptcy only if you have no other way to eliminate or pay off your debts.

The Bottom Line

Bankruptcy is a legal process that allows you to discharge many different types of debts, eliminate calls from collection agencies, and begin rebuilding your financial life. The two different types of personal bankruptcy, Chapter 7 and Chapter 13, allow you to discharge your debts through liquidating your assets or creating a long-term repayment plan.

Before you file for bankruptcy, consider talking to a financial counselor or attorney to explore other options.

Debatable Issues & Moral Questions

What do you think? Is it wrong for people to file bankruptcy just to wipe the slate clean, when in all reality they could fight their way out of debt by working hard and budgeting?