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Beyond bankruptcy: What happens when you fail Chapter 13

Tony Mecia

Filing for personal bankruptcy protection might sound like hitting rock bottom, but a couple hundred thousand people a year reach a lower low: filing bankruptcy and failing to complete it.

People who fail to finish a personal bankruptcy reorganization get socked twice. Their credit scores take huge hits when they file for bankruptcy protection. Then, they don't get a lift from completing the process and remain saddled with the debts that sank them into bankruptcy in the first place.

"Once you get bounced out, it's going to be hard for those people to clean up their credit report," says Daniel Austin, an associate law professor at Northeastern University in Boston who studies bankruptcy. "If they had at least gotten the debt discharged, then that credit entry is noted as discharged in bankruptcy. Now, they've got the bankruptcy and the debt."

Experts say people should file for bankruptcy only as a last resort, and there are two options. You can file what's known as a Chapter 7 liquidation, designed for people with no or little disposable income -- the money left over after you pay an amount for expenses that is determined by the law. Chapter 7 wipes out many debts and allows you to start fresh.

Or you can file a Chapter 13 reorganization, designed for people with more disposable income, but who are overwhelmed with debt. Chapter 13 bankruptcies typically allow consumers to prevent foreclosure on their homes and receive some breathing room from creditors. Most of the debt still must be repaid, under terms of a plan that lasts between three and five years.

In 2015, some 297,000 people are expected to file Chapter 13 bankruptcies, the lowest number since 2006, according to the American Bankruptcy Institute, an industry group. But the vast majority probably will not be finished. Of the 2.6 million Chapter 13 cases closed between 2007 and 2014, only 37 percent resulted in the filer completing the court-approved repayment plan. Some 51 percent were dismissed, and 12 percent were converted to other forms of bankruptcies, according to an American Bankruptcy Institute analysis of Justice Department figures.

Why people fail at bankruptcy
People who work with consumers in financial distress say the numbers jibe with their experiences. They say that many times, people who file for bankruptcy fail to have realistic expectations, and often their circumstances change and make repayments tricky. In Chapter 13 bankruptcies, the filer makes a single monthly payment to a trustee, who disburses it to creditors.

"Sometimes, people don't fully understand what they are signing up for," says Keola Harrington, a financial counselor with Clarifi, a nonprofit credit counseling agency in the Philadelphia area. "When they file, they don't understand they are getting themselves into a repayment plan. With these repayment plans, a lot of things can happen over time."

Sometimes, people relapse into bad habits of not paying their bills. In other cases, their financial circumstances change. Maybe they lose their job or take a pay cut. Although Chapter 13 bankruptcy repayment plans can be modified to reflect those changes, doing so takes effort and money, and many people choose instead to start skipping payments.

When they miss too many payments, the trustee can ask the court to dismiss the bankruptcy case because the plan is no longer workable. If a Chapter 13 case is dismissed, creditors can again start seeking foreclosure or repossession, and the person who filed will continue owing payments to creditors plus interest, minus any payments made during bankruptcy. They may be insolvent for years.

Harrington says some of her clients who are having trouble meeting payments they owe under Chapter 13 feel overwhelmed. Instead of telling their credit counselors that they are unable to meet their repayment obligations, many try to keep up appearances and insist they can pay, even as they fall further behind. "Often times, they just don't pay," she says. "They feel intimidated. They just don't speak up."

The best advice, she says, it to fully understand what a Chapter 13 bankruptcy entails and to communicate with the bankruptcy trustee or credit counselor if problems arise. Missing a few payments can be forgiven, but ignoring the trustee or falling far behind can cause big problems.

In some cases, Chapter 13 reorganizations can be converted to Chapter 7 liquidations, usually if the person's financial circumstances have worsened. But simply converting to Chapter 7 doesn't mean you'll qualify for Chapter 7 relief from your debts. You'll still need to pass the means test, which looks at your ability to pay some of your debts. Your location and family size go into the calculation that determines whether you qualify for Chapter 7 relief.

Maintaining hope
Harrington's clients have emotional needs, too, she says. Some lose sleep. Just listening to them, understanding their backgrounds and treating them humanely can help people enduring financial stress feel valued.

She also tries to offer hope. Even though a bankruptcy filing damages credit scores and carries a stigma, it is still possible to rebuild credit and even own a house someday.

"Once you file for bankruptcy, that's not the end of it," Harrington says. "Bankruptcy is just one step in the process. What are you going to do differently to never wind up here again?"

At Navicore Solutions, a national nonprofit financial counseling agency, Kim Cole works with clients who never expected to file for bankruptcy, yet wound up there because of a significant life event, such as losing a job or a spouse or having a serious and expensive medical condition.

It shouldn't be entered into lightly, she says, but for some people, it can make sense. "Bankruptcy is definitely not a bad thing," she says. "There are people who absolutely need it and it is there for that reason. In the end, it should be one of the last alternatives."

See related: 8 myths surrounding bankruptcy, Card tips for rebuilding credit after bankruptcy, Where to turn for help with overwhelming debt