What to Know Before Filing for Bankruptcy
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People who can’t pay their debts may consider filing for bankruptcy, a process in which they either formally walk away from some or all debts, or renegotiate the terms. Here’s what you need to know before filing for bankruptcy: While it can offer a fresh start for those deep in debt, bankruptcy is a serious decision that can decrease your credit score and borrowing options for years to come.
What is bankruptcy?
Bankruptcy is a federal legal protection for indebted consumers. It’s considered a last resort for people facing more debt than they can readily repay on their current income. Bankruptcy is a formal, legal process where you demonstrate your inability to repay debt and in exchange are allowed to walk away from or change terms of debt. It allows you to start anew — financially speaking — but with legal expenses, a permanent record of the bankruptcy and a tarnished credit score.
Not everyone who struggles with debt is eligible for bankruptcy, though. To apply for Chapter 7 bankruptcy — the most common type for individuals — your household income cannot exceed the median for your state and household size.
Also, before filing for bankruptcy you must visit a credit counselor, who may suggest alternatives such as debt consolidation, changing a student loan repayment plan or refinancing a mortgage to make debt payments more affordable.
There are multiple reasons people file for bankruptcy. According to academic research published in the American Journal of Public Health, the top reasons for bankruptcy include:
- Medical expenses
- Mortgage terms or foreclosure
- Overextending to help loved ones
- Student loans
- Change in marital status
Key differences between Chapter 7 and Chapter 13 bankruptcy
Individuals may file for one of two types of bankruptcy — Chapter 7 or Chapter 13. Roughly two-thirds of consumer filings in recent years have come in the form of Chapter 7, wherein individuals liquidate assets such as a car or home to cover debts.
In Chapter 13 bankruptcy, individuals may preserve some assets (such as a home) while repaying debt over three to five years. However, if a Chapter 13 filer cannot pay debt as agreed under bankruptcy, their case may be reclassified as Chapter 7 and their assets may lose protection.
Chapter 7 bankruptcy is the best option when:
- Credit and debt counseling show no other viable options.
- You cannot pay debts off within five years and don’t anticipate increased income.
- You relinquish assets (home equity, car) to become debt-free.
- You are willing to carry the negative mark of bankruptcy on a credit report for 10 years.
- You earn at or below median income for your household size and state.
Chapter 13 bankruptcy is the best option when:
- Credit and debt counseling show no other viable options.
- You have sufficient income to repay debt within five years.
- You have assets to protect (car, home).
- You are willing to carry the negative mark of bankruptcy on a credit report seven years.
- You have no more than $419,275 in unsecured debt, such as credit cards, and no more than $1,257,850 in secured debt, such as a mortgage. (The amounts are increased periodically; these figures are current as of April 1, 2019.)
Some debts can’t be discharged
Bankruptcy is not a solution to budgeting missteps or living beyond your means. It also doesn’t wipe out certain types of debt:
- Student loan debt traditionally cannot be discharged in bankruptcy. (However, student loan debt repayment terms may be renegotiated outside the bankruptcy process.)
- Alimony and child support cannot be discharged in bankruptcy.
- Court and criminal fees cannot be discharged in bankruptcy.
- Secured creditors (mortgage or auto lenders) may repossess property if you default on agreed-upon payments.
Bankruptcy, in other words, is not a way out of student loans or payments owed to an ex-partner or courts. However, bankruptcy may reduce other debts and improve your overall financial picture so that the above obligations become easier to budget for and pay.
Bankruptcy isn’t cheap
Filing for bankruptcy isn’t cheap. Those who file must pay filing fees and attorney fees. Pre-bankruptcy credit counseling may cost about $50 or be provided for free if you can’t afford to pay. As of late 2018, the total cost to undergo bankruptcy ranged from $1,585 to $2,935 for Chapter 7 and $3,260 to $5,410 for Chapter 13, according to LendingTree data.
Bankruptcy will cost you in other ways, too. The filing appears on your credit report, typically lowering your credit score by 100 to 200 points immediately following filing and remaining on your report for seven or 10 years. A low credit score means less favorable rates on loans and credit cards in the future. You can apply for new credit in the years following bankruptcy, but you may want to consult your bankruptcy attorney first — and you may not be eligible for very attractive interest rates or terms.
However, Chapter 13 filers who continue to pay as agreed for mortgages or auto loans during their Chapter 13 period may through this good financial behavior raise their credit score over time. LendingTree research indicates that 75% of those who filed for bankruptcy can within five years restore their credit score to at least 640, the threshold of eligibility for many lenders.
The bottom line
Bankruptcy might feel like an admission of defeat, but it could be the fastest way out of debt after a period of unpredictability or an economic shock such as a job loss, change in family status or unforeseen expense. For some, bankruptcy is a new financial beginning and the first step toward a more secure future.