Bankruptcy carries a huge stigma. Many of us see it as a financial death sentence, an admission of failure. That’s not what it’s meant to be. It’s supposed to be a fresh start, a second chance for people buried in debt. But when do you need that fresh start? When should you file for bankruptcy?
Let’s take a closer look.
Bankruptcy Basics
Bankruptcy is designed to provide an escape for people who have more debt than they can possibly pay. You will need to demonstrate that you do not have the capacity to pay your debts. If you can pay, you will be expected to do so.
If you have assets above a minimum level, they can be seized and sold to pay your creditors. Your creditors will have the right to contest the discharge of your debts.
Bankruptcy can still be an effective way to clear certain types of debt and start over if you are in true financial distress.
There are several types of bankruptcy. Most personal bankruptcies fall into two types: Chapter 7 and Chapter 13, named for the chapters of the bankruptcy code that describe them.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy is for people with limited income and limited assets. If your gross household income is below your state’s median income, you will qualify. If it is above the median you will have to prove that you cannot pay back your debts.
Chapter 7 bankruptcy is sometimes called “liquidation bankruptcy”. The debtor’s assets may be sold to help pay creditors. You will be able to retain some basic assets that are exempt from liquidation. Debtors who have few or no assets may simply have debts discharged with no asset sale.
Chapter 13 Bankruptcy
If your income is above your state’s median and the court rules that you have the ability to pay your debts, you can only file for Chapter 13 bankruptcy. The court will set up a payment plan managed by a trustee. Debts that remain after the completion of the payment plan can be discharged.
Bankruptcy is a complex topic and there are many other differences between these two types of bankruptcy. Check this guide to Chapter 7 vs Chapter 13 bankruptcy for more information!
When Should You File Bankruptcy?
Bankruptcy is a useful and sometimes necessary tool for people under severe debt stress. That doesn’t mean it’s something to treat casually. It’s a complicated and potentially expensive process with significant consequences.
Here are some points to consider before you decide to file.
What Kind of Debts Do You Have?
Not all debts can be discharged in bankruptcy. Alimony and child support cannot be eliminated or reduced in bankruptcy. Most recent tax debt, most student debt, debts owed to government agencies, and some other debts cannot be discharged.
Unsecured debts like credit card debt, medical debt, personal loan debt, and payday loan debt can generally be discharged in a Chapter 7 bankruptcy.
Secured debts like mortgages and car loans are more complicated. Your personal liability for the debt will be extinguished: you won’t be sued over the debts. The lender can still foreclose on the property or repossess the vehicle if you can’t keep up with the payments.
If your debts cannot be discharged, bankruptcy is not a solution for you.
How Much Do You Owe?
Assessing your debts is a critical part of deciding whether or not bankruptcy is an option to consider. You’re not just interested in the total amount you owe, but rather in the amount you owe relative to what you can afford to pay.
There are two general rules of thumb.
- If your debts equal more than half your income, you may wish to consider bankruptcy.
- Calculate the time it would take to pay your debts if you stop using new debt and use everything above what you need for basic living for debt payments. If it’s more than 5 years (some experts would say 3 years), bankruptcy may be a good option.
Neither of these is a signal that you should definitely file for bankruptcy. They are signs that you should consider bankruptcy as an option.
Have You Tried Alternatives?
There are several ways to handle debt, and you may wish to try one or more of them before considering bankruptcy.
- Negotiation. Creditors don’t want you to file for bankruptcy: that will leave them with nothing. If you approach your creditors and explain your situation they may offer concessions – like a rate cut or a longer loan term – that make it possible to pay your debts.
- Debt consolidation. You may be able to take out a single loan, pay off your other debts, and pay off the new loan with a single monthly payment at a lower interest rate. Consolidation is often used for credit card debt. It’s only effective if your credit is good enough to get a new loan on advantageous terms.
- Debt settlement involves negotiating with your creditors to reduce the amount you owe. You can do this yourself or use a debt settlement company. Debt settlement can hurt your credit – the debts will be listed on your credit report as settled for less than the original amount – so it’s not a good option if you want to protect your credit.
- Credit counseling. Non-profit credit counselors offer debt management plans. You’ll make a single payment to the counseling service and they will pay your creditors. They will also negotiate for better deals. A credit counselor can also help you decide whether you need to file for bankruptcy.
If you’re looking at these options, look carefully, especially if you’re considering retaining a company or service to help. Debt relief and credit repair scams are rampant. Shop carefully and check the reputation and record of any service you’re considering.
What Have You Got to Lose?
Bankruptcy can be a fresh start, but it will not simply wipe away your debts with no penalty. There are real consequences, and you’ll have to consider them if you’re considering bankruptcy.
Several parts of your life may be affected.
- Your credit. Chapter 7 bankruptcy will remain on your credit report for 10 years, Chapter 13 for seven. There will be an impact on your credit. If your credit is still adequate this could be a serious issue. If your credit has already been battered this may not be a concern: many people find that their credit actually improves post-bankruptcy.
- Your assets. You will be allowed to retain basic assets needed for survival, including a car of modest value and potentially your home, depending on the equity you have in it. Assets beyond the basic level may be seized and sold to pay your creditors. Consult a bankruptcy lawyer to evaluate your assets: many offer a free initial consultation.
- Your money. Bankruptcy is a complex process and most filers need an attorney. This is expensive. There are also significant fees. If you have a simple Chapter 7 case you may be able to file using Upsolve, a free app that assists bankruptcy filers.
- Your co-signers. If you have co-signers on your debts, bankruptcy will leave them liable for the entirety of the debt. That can put serious strain on relationships with the co-signers.
These potential penalties have to be considered if you’re deciding whether you should consider bankruptcy.
Do You Have Ongoing Credit Needs?
If you file successfully for bankruptcy most of your unsecured debts will be discharged. The downside is that you won’t be able to file again for eight years.
This is a particular consideration if you have ongoing medical needs. Bankruptcy can discharge medical debt incurred up until the time you decide to file for bankruptcy, but any subsequent debt will not be included.
If you have a chronic medical problem that will continue to rack up costs you’ll have to decide what’s the best time to file, because it will be some time before you can use bankruptcy again.
The Danger Signs
If you’ve evaluated those questions and decided that you should consider bankruptcy, look for these warning signs.
- Your debts won’t stop growing. If you’re paying all you can and your debts are still growing, that’s a sign that you’re not even keeping up with the interest. That makes bankruptcy a more realistic option.
- You’re compromising the interests of others. If your ability to care for children or elders who are your responsibility is being affected by debt payments, it might be time for a fresh start.
- You’re using retirement savings to pay debt. You probably see covering your debts as an obligation, but if you’re thinking of digging into your retirement savings, don’t do it. If that’s your only remaining option bankruptcy is probably a better choice.
- Debt collectors are hounding you. If you have multiple debts in collections and you’re keeping your phone off to avoid collectors that you can’t pay, it’s time to consider bankruptcy.
- You’re borrowing to pay debt. There are times – like debt consolidation – when it makes sense to borrow to pay debt. If you’re drawing from one credit card to pay another or considering payday loans, it may be time to start over.
- You’re facing lawsuits or garnishment. Debt collectors can sue you, and if they do they can garnish your wages, leaving you unable to pay other debts and potentially without enough to cover basic expenses. Bankruptcy could be a better choice.
If one or more of these signals is present, that’s an indication that you should be considering bankruptcy.
The Decision
Filing for bankruptcy is a big decision. Nobody can make it for you, but you can get advice that will help you make the best decision for you.
Non-profit credit counselors offer free initial consultations that can help you evaluate your finances and decide whether bankruptcy is your best option. Many bankruptcy lawyers offer free initial evaluations that will help you understand what type of bankruptcy you’d need and the process you’d have to use.
Bankruptcy is not shameful. It is not the end of your financial life: many people have been through bankruptcy and fully recovered. It’s a tool that’s available for you to use. It may not be a tool that you want to use, but there are times when it’s the best choice. Understanding bankruptcy and its alternatives will help you decide whether it’s the right tool for your situation!
