Topics
Why Avoid Bankruptcy?
There was a time when bankruptcy was considered
a stigma. Filing for bankruptcy was considered shameful, an admission that one
could not manage one's personal finances.
Today, the stigma appears to have lifted. In fact,
rampant credit card debt has driven many Americans to choose the bankruptcy
route -- more than 1.8 million bankruptcy petitions were filed during the
2005 calendar year.
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What Is Bankruptcy?
Bankruptcy was created to protect the financial health
of the jobless and the infirm by eliminating high levels of debt. There are
two ways to file for bankruptcy, each with its own rules. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Bankruptcy Reform Act), made many changes in bankruptcy law.
Under a Chapter 7 bankruptcy filing, many debts are eliminated,
but the filer must liquidate personal assets to pay down some of the debt. Personal
property is sold by a bankruptcy trustee, who then uses the proceeds to pay
creditors. Some assets are exempt if they are considered necessary to support
the filer and any dependents, but state and federal laws vary widely. In general,
a percentage of home equity and disability benefits are exempt, and Chapter
7 filers may be allowed to keep any money or property they obtain after filing.
Chapter 7 bankruptcy can be filed once every eight years.
A Chapter 13 filing does not erase debt. Rather, it requires
the filer to set up a repayment plan, typically over a three- to five-year period,
in exchange for keeping personal assets. The Bankruptcy Reform Act of 2005 states that anyone with income above the state median will have to file for Chapter 13 and pay back at least a portion of their debts. In general, homes will only be protected if owned for at least 40 months. Chapter 13 bankruptcy can only be filed once every two years.
Certain debts cannot be erased under any bankruptcy
filing, including alimony, child support, property settlements, criminal judgements
and fines, student loans, and most taxes. In addition, a bankruptcy filing will
not allow you to keep property that secures a loan, such as an automobile or
home, unless you repay the loan.
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Who Should File?
In general, filing for bankruptcy
should be avoided. Filing, however,
may help to begin a financial recovery if:
- You cannot meet debt obligations on current income.
- Attempts to negotiate payments with creditors have failed.
- Your ratio of debt to annual income is 40% or more.
- Previous attempts to reduce debt have failed, particularly with the help of a credit counselor or debt reduction plan.
- You have charge-offs on your credit history. Charge-offs appear when you have debts that are more than 250 days past due that are written off by your creditors for accounting purposes. A series of charge-offs and bankruptcy are both black marks on your credit report, but a bankruptcy filing demonstrates that you have at least dealt with the debt.
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Drawbacks to Bankruptcy
A bankruptcy filing is a black mark on your credit
history. This can make it difficult to obtain loans, mortgages, and credit cards.
Both a Chapter 7 and a Chapter 13 bankruptcy will appear on your credit report for 10 years. During this time, you may be subject to several financial hardships.
- Secured loans may be more expensive to acquire. Only a handful of lenders may approve you for mortgage and car loans. Acquiring a loan or mortgage may require an initial down payment of as much as 50%, and you may need to accept interest rates significantly higher than those offered to people with clean credit histories.
- Unsecured loans may be impossible to acquire. Credit card companies typically reject applicants with bankruptcies on their credit histories. You may only be able to obtain a secured credit card, which requires a security deposit typically equal to the amount of credit initially granted. Fees for these cards are generally higher than for unsecured cards, and issuers may charge an application fee.
- Not all retirement account assets are protected. Qualified retirement accounts, such as 401(k)s, are protected in all bankruptcy filings. And, up to $1 million in an individual retirement account is protected. Federal law requires that only those assets needed to support a filer and dependents are exempted, so you may only be able to keep a portion of an IRA account.
- New legislation makes filing for bankruptcy more difficult.
The Bankruptcy Reform Act of 2005 prohibits some people from filing for Chapter 7
bankruptcy; adds to the list of debts that people cannot get rid of in bankruptcy;
makes it harder for people to come up with manageable repayment plans; and limits
the protection from collection agencies for those who file for bankruptcy. In addition, anyone filing for Chapter 7 or Chapter 13 must undergo credit counseling at their expense six months prior to filing for bankruptcy and will also be required to take a financial-management course
after filing.
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Alternatives to Bankruptcy
Bankruptcy, and the resulting credit difficulties,
is not the only way to manage excessive debt. You can try to negotiate a payment
plan with a creditor and perhaps reduce your debt. Credit card companies faced
with the rising number of bankruptcy filings may prefer to get some of what's
owed them rather than have the entire debt erased.
You can conduct these negotiations on your own, with
the help of an attorney, or through a professional credit counselor, who specializes
in credit negotiations and will charge less than an attorney for the service.
Payments for the negotiated debts can be deducted directly from your paycheck
by the counseling service, which then distributes the money to creditors. Credit
counselors will also work with you to rebuild your credit and improve your long-term
financial situation.
Though the stigma surrounding bankruptcy has lifted,
it should still be seen as a last resort after all other methods of settling
debt have been exhausted. The thought of your debt being erased may be attractive,
but the financial hardships bankruptcy can create far outweigh any benefits.
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Where to Turn for Help
Credit Counseling
Consumer Credit Counseling Service (800-388-2227, www.nfcc.org)
-- This organization has offices nationwide and charges a nominal
fee or nothing for its counseling services.
General Information
Myvesta.org (800-680-3328, www.myvesta.org) -- Formerly the
Debt Counselors of America, this organization offers a variety of
debt reduction materials, including free publications, debt-reduction
packages, and credit report information.
The Institute
of Consumer Financial Education (619-232-8811, www.financial-education-icfe.org)
-- Offers materials to help consumers manage their finances,
including the Do-It-Yourself Credit File Correction
Guide.
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Summary
- Chapter 7 bankruptcy erases debt but forces you to liquidate your assets. It can be filed once every eight years and will remain on a credit report for 10 years.
- Chapter 13 bankruptcy allows you to keep your assets in exchange for setting up a repayment plan. An individual can file once every two years and the bankruptcy will appear on a credit report for 10 years.
- Filing for bankruptcy will make loans more costly and may make unsecured loans impossible to obtain.
- Qualified retirement plan assets, such as 401(k)s, are protected under all bankruptcy filings, and assets of up to $1 million in IRAs are also protected.
- An alternative to bankruptcy is negotiating a repayment plan with creditors. For a modest fee, a professional credit counselor can assist you with these negotiations and help you improve your long-term financial health.
Checklist
- Consolidate high-interest credit card balances into a single low-rate account to bring the debt under control on your own.
- Seek help from a reputable consumer credit counselor. Avoid those who only want to offer you loans or steer you toward bankruptcy without first exploring all other alternatives.
- Speak with a bankruptcy attorney for advice about your options.
