If your debts have become unmanageable or you're facing foreclosure on your home, you might be thinking about declaring bankruptcy. While bankruptcy may be the only way out for some people, it also has serious consequences that are worth considering before you make any decisions. For example, bankruptcy will remain on your credit report for either 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. It could also mean higher insurance rates and even affect your ability to get a job or rent an apartment. This article explains how bankruptcy works and also offers some alternatives to bankruptcy.

Key Takeaways

  • Bankruptcy can do severe damage to your credit score and should be considered as a last resort.
  • As an alternative, you may be able to negotiate with your creditors and work out a payment plan or other satisfactory arrangement.
  • If you decide to file for bankruptcy, you have two basic options: Chapter 7 and 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.

What to Do Before Filing 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, there are alternatives that are worth exploring. They are less costly than bankruptcy and likely to do less damage to your credit record.

For example, find out if your creditors are 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 forbearance (postponing payments for a period of time), repayment plans (such as smaller payments stretched over a longer period), or loan modification programs (which might, for example, lower your interest rate for the remainder of the loan).

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

How to File for Bankruptcy

If you've decided to file for bankruptcy, your first step should usually be to consult an attorney. While it is possible to file without one, "seeking the advice of a qualified attorney is strongly recommended because bankruptcy has long-term financial and legal outcomes," the Administrative Office of the U.S. Courts notes on its website. (Bankruptcy is governed by federal law, and cases are handled by federal bankruptcy courts, although some rules differ from state to state.)

Before you file, you'll be required to attend a counseling session with a credit counseling organization approved by the 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 Federal Trade Commission.

If you still wish to proceed, your attorney can advise you on which type of bankruptcy is more appropriate for your situation.

Types of Personal Bankruptcy

In the case of individuals, as opposed to businesses, there are two common forms of bankruptcy: Chapter 7 and Chapter 13. Here is a brief description of how each type works:

Chapter 7. This type of bankruptcy essentially liquidates your assets in order to pay your creditors. Some assets—typically including part of the equity in your home and automobile, personal items, clothing, tools needed for your employment, pensions, Social Security, and any other public benefits—are exempt, meaning you get to keep them.

But your remaining, non-exempt assets will be sold off by a trustee appointed by the bankruptcy court and the proceeds will then be distributed to your creditors. Non-exempt assets may include property (other than your primary residence), recreational vehicles, boats, a second car or truck, collectibles or other valuable items, bank accounts, and 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 income and few assets. Your eligibility for it is also subject to a means test, as explained bellow.

Chapter 13. In this type of bankruptcy, you are allowed to retain your assets, but must agree to repay your debts over a specified period of three to five years. The trustee collects your payments and distributes them to creditors. Chapter 13 bankruptcy is normally chosen by people who want to keep their non-exempt property intact or buy time against foreclosures or property seizures.

The 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 first compares 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'd 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 this 122A-2 Form.

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Image by Julie Bang © Investopedia 2020

Listing Your Debts

In filing for bankruptcy, you will also be asked to supply the court with a list of your all the money you owe. Your debts fall into two categories:

  • Secured debts. These include loans in which the creditor has a security interest in the 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: These debts are not secured by property or other collateral. Examples include credit card debt, medical bills, and personal unsecured loans.

The bankruptcy court considers secured debt to be of 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 in any way.

The court will send your creditors a notice that the debts have been discharged. A copy will also be sent to your lawyer as well as 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 between four and 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. 

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

As mentioned above, bankruptcy will remain on your credit report for either 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.

One tool for doing that is a secured credit card, where you make a deposit with the issuing bank, which then becomes your credit line. 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, non-secured 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—is not the end of the world.