People who have racked up more debt than they can repay are sometimes left to ponder whether they should file for bankruptcy. There are several reasons it might make sense to take the plunge and file for Chapter 7 bankruptcy or Chapter 13 bankruptcy. However, making that decision also carries some serious consequences. Here is what you need to know.
- If you are overwhelmed by debt, filing for Chapter 7 or Chapter 13 bankruptcy may be a solution, but it is often not the only one.
- Before you decide, it's worth consulting a reputable credit counselor and trying to negotiate with your major creditors.
- If your creditors won't negotiate—and you lack the income and assets to pay—you may have no alternative to bankruptcy.
- Bear in mind that a bankruptcy will remain on your credit record for seven or 10 years and make it difficult to borrow in the future. Bankruptcy can also mean higher insurance rates, among other negative consequences.
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Reasons to File for Bankruptcy
There are some circumstances in which filing for bankruptcy may be your best (or only) recourse:
- You've already tried to negotiate. Suppose that you have attempted to negotiate a repayment plan with one or more major creditors, as experts often recommend as a first step, but they have not budged. They want their full payment and aren't willing to be paid out over time—and you don't have the means to make that payment. This can leave you with few options other than to file for bankruptcy.
- Your liabilities far exceed your income and assets. Another major reason some individuals file for bankruptcy is that they simply cannot pay their debts, and just servicing the debt—that is, making the required monthly payments—exceeds the monthly income they generate. For example, consider someone who owes $500,000 to a bank and whose monthly mortgage payment is $4,000. If this person only has income of $2,000 a month, and another $25,000 in assets to draw on, they may have few other options than to file for bankruptcy. Otherwise, they will deplete their assets in about a year and be completely unable to make that $4,000 payment going forward.
If you owe back taxes to the Internal Revenue Service (IRS) that you can't afford to pay, you have several alternatives to filing for bankruptcy. One is negotiating an installment payment plan with the IRS. Another is an "offer in compromise," in which the IRS will agree to settle your debt for a lower amount.
Negative Impacts of Bankruptcy
Filing for bankruptcy is sometimes the right decision, but it is not without consequences. Those include:
- Your credit will be shot. Anyone considering bankruptcy needs to keep in mind that their credit reports and credit score will take a major hit—one that can last for years. In the case of Chapter 7, bankruptcy will remain on your credit reports for up to 10 years; for Chapter 13, it's seven years. That can make it impossible to get a loan or a regular credit card, except at exorbitant rates. Having a bankruptcy on your credit report can also mean higher insurance premiums and even affect your ability to get a job or rent an apartment.
- You may lose your property. In a Chapter 7 bankruptcy, often referred to as liquidation, a court-appointed trustee will dispose of many of your assets in order to pay your creditors. Those assets include real estate (other than your primary residence), a second car or truck, boats, valuable collections, bank accounts, and non-retirement investments. You are allowed to keep what's referred to as exempt property, such as a portion of the equity in your home and car, personal items, clothing, any tools needed for your work, and retirement accounts. In a Chapter 13 bankruptcy, you are allowed to keep your assets, as long as you adhere to a three- to five-year plan to repay your creditors.
- There could be a psychological impact, too. Besides its dollars and cents impact, bankruptcy carries a stigma in our society. While some people may be unaffected by that, others can come to feel that they're losers, failures, or have no hope of ever turning their finances around. Or they may worry that their neighbors and loved ones will feel that way. In short, it's worth considering how bankruptcy might affect your mental health and your relationships with those around you.
How Much Does Bankruptcy Cost?
Another consideration is the cost of filing for bankruptcy. Filing typically costs a couple of hundred dollars, but hiring an attorney to represent you and protect your interests could cost a great deal more. Although individuals can act on their own behalf without an attorney, by going it alone you run the risk of losing certain rights or property. Generally speaking, because of their knowledge of bankruptcy law and experience with the courts, an attorney can be worth the money.
After bankruptcy, you will probably find it difficult to get a credit card, except at a very high interest rate. One alternative is a secured credit card, where you put some money on deposit with the issuer, which you can then borrow against.
What Happens When You Declare Bankruptcy?
As mentioned above, bankruptcy will remain on your credit reports for years into the future, and those reports may be consulted by potential lenders, insurance companies, landlords, employers, and others. You can't do anything to remove the information ahead of schedule, but it's worth checking to make sure that it's accurate and doesn't cast you in an even more negative light. You are entitled to at least one free report each year from each of the three major credit bureaus—Equifax, Experian, and TransUnion—through the official, federally authorized website, AnnualCreditReport.com. If you find any errors on a report, you should ask that that they be corrected.
Aside from your credit report, bankruptcy is also a matter of public record. So bear in mind that anyone can request a copy of the filing.
Because your credit is severely damaged by bankruptcy, you may find it difficult to borrow if you need to, including a loan to buy a car or a mortgage to buy a home. It will also be difficult to obtain a conventional credit card. One alternative is to apply for a secured credit card, where you deposit money with the card issuer to back up your line of credit. If you use the card judiciously, making all your monthly payments on time, you may soon qualify for a regular, unsecured credit card. A secured credit card is often recommended as a tool for rebuilding a damaged credit record.
What Is Chapter 7 Bankruptcy?
In a Chapter 7 bankruptcy, a court-appointed trustee will sell off your personal assets (except for those that qualify as exempt) and use them to pay your creditors.
What Is Chapter 13 Bankruptcy?
In a Chapter 13 bankruptcy, you are allowed to keep more of your personal assets than in a Chapter 7 bankruptcy, but you must agree to repay your creditors over a certain period of time and adhere to that plan.
What Is Chapter 11 Bankruptcy?
Chapter 11 is a type of bankruptcy that is typically used by businesses rather than individuals. Businesses can also file for bankruptcy under Chapter 7. Chapter 11 allows the business to reorganize rather than simply be liquidated.
The Bottom Line
Bankruptcy can be the only solution to some people's financial problems, but it isn't to be entered into lightly. Before making any decisions, it's worth consulting a reputable credit counselor and trying to negotiate with creditors to see if you can work out a payment plan. Credit counseling is also a mandatory step in the bankruptcy process.
Speaking with a lawyer before you've made up your mind may also be a good investment. If you ultimately decide that you have no alternative but to file, remember that the damage to your credit will be long-lasting but not permanent. By taking the right steps in the future, you can gradually rebuild your credit and get back on track.