Bankruptcy has negative connotations and stigma, and understandably so. But sometimes it’s the best solution to a serious money problem.
So, when and why should you declare personal bankruptcy—and when and why shouldn’t you? And, if you do decide that bankruptcy will ultimately help your finances, how can you make the best of the situation? Consider the following tips if you are thinking about bankruptcy.
(Bankruptcy uses some terminology you may not be familiar with, so you may want to refer to this glossary from the U.S. Courts for explanations of some terms.)
Why Should I Avoid Bankruptcy?
If declaring bankruptcy were without consequences, a lot more people would use it to quickly wipe out their debt. Make that debt vanish. Make those collection calls stop. No more wage garnishments!
The problem, however, as you likely know, is that bankruptcy can have long-term consequences. A record of your bankruptcy can remain on your credit report for seven to 10 years.
Any employer doing a background check could find your bankruptcy there. That might render you ineligible for a job or it could be a mark against you when considering job candidates.
A bankruptcy in your personal file could make it harder when applying to rent an apartment or obtain a loan, and you might have to pay higher interest rates. Clearly, bankruptcy is not to be taken lightly.
You may be able to avoid bankruptcy even if your debts are large, so consider all your options before committing to it. In many cases, your long-term finances might be better off if you find other ways to get out of a pile of debt. Consider the following list and read more here and here.
● Consolidate your debt.
● Make extra payments to pay down debt sooner.
● Earn extra income.
● Work with a debt counselor to create a repayment plan.
● Examine how you got into debt and try to avoid those behaviors in the future.
When Should I Declare Bankruptcy?
Despite the long-term drawbacks of bankruptcy and the overall benefits of avoiding it, for some people, the burden of debt is just too great. In those cases, the best way out can be to surrender, declare bankruptcy and get a fresh start.
The first thing you should know is that bankruptcy won’t erase all debt. For example, the government could still collect on defaulted student loans by garnishing future Social Security benefits. You also won’t get relief from paying child support, alimony, tax liens or court fees and penalties. But with one move, you can say goodbye to mounting stress, collection calls, wage garnishments and lawsuits.
Declaring bankruptcy could wipe out credit card debt, medical bills, personal loans, past-due rent and utility bills and more. But your credit score certainly will go down, and you’ll pay the price of having a bankruptcy on your financial record for several years.
However, once your debt is discharged, you can begin your financial recovery. Do all the right things, including paying bills in full and on time, and in a year or two, you’ll likely see your credit score improving.
In some cases, bankruptcy is the best way to turn around a chronically bad financial situation, and a few years from now, you could be ahead of where you were before.
You Have Decided to Declare Bankruptcy: What to Do Now
If you decide on bankruptcy, how should you proceed? First, you’ll need to meet certain requirements, including demonstrating that you can’t repay your debts and completing government-approved credit counseling. Then, learn about the options.
The two common types of personal bankruptcy are Chapter 7 and Chapter 13. Despite some similarities, such as protection from foreclosure or repossession, wage garnishment and utility shutoffs, these two options are quite different. While Chapter 7 bankruptcy can result in discharging one’s debt after completing a few steps, Chapter 13 sets up a three- to five-year repayment plan.
What Is Chapter 7 Bankruptcy?
Chapter 7 provides the type of fresh start that people typically picture when thinking of bankruptcy. It could be a viable solution if:
● Your debts make up more than half of your annual income.
● Repaying your debt in full could take five years or longer.
● Your debt is affecting your sleep and creating other tangible stress.
● Your monthly income is below your state’s median level.
● You have little or no disposable income.
If those conditions apply to you, the next steps could be:
1. Fill out detailed forms on your assets, liabilities, income, expenses and overall financial situation.
2. Complete mandatory pre-bankruptcy credit counseling.
3. If bankruptcy is determined as the best option, file a petition (the forms filled out in step No. 1) for bankruptcy at the local bankruptcy court.
4. Pay for the filing, court fees and attorney fees. (Here’s a rough guide to fees.)
5. A bankruptcy trustee will verify your information.
6. Meet with the trustee and creditors if any of them seek to pursue the debts you are trying to discharge.
7. Complete a debtor education counseling session.
If all goes well, your qualified debts will be discharged.
What Is Chapter 13 Bankruptcy?
With Chapter 13 bankruptcy, you may keep your property in exchange for repaying your debt in part or in full. In bankruptcy court, your attorney will negotiate a three- to five-year repayment plan. Once you have completed the plan, your debt will be discharged.
Chapter 13 is sometimes referred to as a “wage earner’s plan,” as it is intended for people who have a source of income but have outsized debts.
Be Aware of the Long-Term Impact of Bankruptcy
Even if bankruptcy is the best or least bad solution for you, it always comes with long-term costs. It is no small thing that your credit score will reflect this financial scar for years. You might have to wait a long while before buying a home or qualifying for a large loan or line of credit. But as long as you borrow responsibly after discharging your debt, you could be living with relief from the accumulation of debt and stress that has been holding you down.
Allan Kunigis is a financial freelance writer based in Shelburne, VT. He has written about personal finance for more than two decades.