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Should I File for Bankruptcy?

Christy Bieber, The Motley Fool

Bankruptcy is a legal process designed to help you reorganize your debt and to have some or most of your debt discharged -- which means it can't be collected. Bankruptcy involves getting credit counseling, filing court papers, and going through a formal process whereby some of your creditors are partially repaid either through a payment plan or through the sale of some of your assets. Filing for bankruptcy is one of the more personally and financially traumatic processes you can go through. But filing for bankruptcy can also give you a fresh start under the right circumstances -- and could even be an important first step in rebuilding your credit.

The decision to file for bankruptcy is not to be taken lightly, so it's important to understand how bankruptcy will impact your finances. Getting legal assistance is often an essential part of the process as well. If you're not yet ready to talk to a lawyer, this guide can give you some insight into the pros and cons. Just remember that it's no substitute for legal advice!

Stack of bills labeled "past due" and "account closed."

Image source: Getty Images.

Types of bankruptcy

Each kind of bankruptcy is named for its own chapter in the bankruptcy code:

  • Chapter 7 Bankruptcy: This is called liquidation bankruptcy, and it's one of the two types of bankruptcy most individuals file.
  • Chapter 9 Bankruptcy: Individuals don't really need to worry about this; Chapter 9 regulates municipal bankruptcy.
  • Chapter 11 Bankruptcy: Corporations often file for Chapter 11 bankruptcy to reorganize debts while continuing to operate their businesses.
  • Chapter 12 Bankruptcy: Most individuals don't need to worry about this type of bankruptcy, either. It helps farmers with regular annual incomes to restructure and reorganize debts.
  • Chapter 13 Bankruptcy: This is the second type of bankruptcy filed by most individuals in financial trouble, involving reorganization rather than liquidation.

What is Chapter 7 bankruptcy?

Chapter 7 bankruptcy is often called liquidation bankruptcy, because many of your assets become part of your bankruptcy estate during the process. However, the good news is that only nonexempt assets are taken and sold in order to repay creditors. Exempt property does not need to be turned over. Examples of property typically considered exempt and that you get to keep in bankruptcy include:

  • Equity in your primary home
  • Retirement accounts (such as 401(k) and IRA accounts)
  • Tools of the trade (equipment and tools you need to do your job)
  • An inexpensive vehicle that you need to get to work
  • Low-value personal property

Nonexempt assets can include things such as bank accounts, expensive vehicles, valuable jewelry, expensive artwork, properties that are not your primary home, and investment accounts. The specific laws on which properties are exempt and which are not vary by state.

Once property has been turned over to the bankruptcy estate and sold, the money is distributed among your creditors. The bankruptcy code specifies how the money is divided and which creditors have priority claims. Any remaining balance of eligible debt is discharged once creditors have received their portion of the proceeds from the bankruptcy estate. You do not have to pay it back, and creditors cannot continue to try to collect.

What is Chapter 13 bankruptcy?

Chapter 13 bankruptcy is most often filed by individuals who don't qualify for Chapter 7 bankruptcy because they make too much money. You do not have to turn over assets under a Chapter 13 bankruptcy filing. Instead, a payment plan is negotiated under which you repay some of your debts over three to five years. The payments you're required to make are based on your income and debt balances, and the money is paid to a trustee who distributes the funds to creditors. Upon successful completion of the Chapter 13 repayment plan, any remaining balances on eligible debt are discharged.

If you become temporarily unable to make payments under your payment plan, you can request that the court modify the plan. You could have payments temporarily suspended or reduced, depending upon the reason for your inability to pay.

If you don't comply with the terms of your repayment plan or are unable to make payments over the long term, your bankruptcy case may be dismissed. Your remaining debt balance would not be discharged if your case is dismissed, but you could potentially file for bankruptcy again. You could also request to have your case converted to a Chapter 7 if you have experienced a decline in income or an increase in necessary monthly expenses and can now fulfill the Chapter 7 means test requirements.

Should I file for bankruptcy?

Now that you understand the different types of bankruptcy you'll most likely be able to file as a consumer, you also need to know the key factors that determine whether a bankruptcy filing is right for you:

  • Can collectors still come after me if I file for bankruptcy?
  • What kind of bankruptcy am I eligible for?
  • Will I lose assets because of the bankruptcy filing?
  • Is my debt dischargeable in bankruptcy?
  • Is there another way I can pay back my debt?
  • What alternatives to bankruptcy do I have if I can't find a way to pay back debt?
  • What do I have to do before filing for bankruptcy?
  • What are the pros and cons of bankruptcy?
  • How will bankruptcy impact my credit and my financial future?

Can collectors still come after me if I file for bankruptcy?

One of the main reasons people file for bankruptcy is to get relief from aggressive debt-collection efforts.

If you file for bankruptcy, debt collectors have to stop pursuing you during the bankruptcy proceedings. When you file, an automatic stay goes into effect that prevents continued collections. The automatic stay typically remains in effect throughout your bankruptcy. An automatic stay can even pause foreclosures or repossessions. And any creditors who are currently garnishing your wages but receive notification that you've filed for bankruptcy are generally required to stop the wage garnishment.

However, some creditors can petition for relief from the automatic stay. If a secured creditor -- such as a mortgage lender or auto loan lender -- petitions for relief from the automatic stay, they ask the court to allow them to try to collect on your debt. The court will usually grant relief to secured creditors -- so they can collect -- unless you can prove that you have enough equity in the property to repay what you owe.

If you have unsecured credit, such as credit card debt, the creditor is unlikely to petition for relief from the automatic stay. In some cases, it can happen. And if the creditor petitions and proves the debt won't be discharged in bankruptcy, the court may grant the petition and allow the collector to continue trying to collect.

There are some exceptions to this automatic stay. If you have repeatedly filed for bankruptcy and had cases dismissed within the past year, the automatic stay will either last for just 30 days (after the first bankruptcy in the past year) or won't go into effect at all (if it's your third or subsequent time filing). You can petition to have the court extend the automatic stay, but there's no guarantee this will succeed.

What kind of bankruptcy am I eligible for?

This will impact your decision because, as mentioned above, Chapter 7 bankruptcy and Chapter 13 bankruptcy work very differently.

Chapter 7 Bankruptcy is available only to individuals who can pass a means test in one of two ways:

  • If your current income is below the median for your household size in your state, you can file for Chapter 7. You'll need to fill out Form 122A-1 to calculate your income and determine whether you can meet this test. You can find the median income for your state on the Justice Department website.
  • If your income is above the median income for your state, you must determine whether you have sufficient disposable income to repay your debt. If you don't, you can file for Chapter 7. Complete Form 122A-2 to do this calculation and determine whether your necessary monthly expenses take up enough of your income to qualify for Chapter 7. Only certain expenses can be counted when determining if you have income to pay your creditors. This includes out-of-pocket healthcare expenses, housing and utility costs, and transportation expenses.

If you don't pass the Chapter 7 means test, you will have to file for Chapter 13. If you do pass one of these two means tests, you can file for Chapter 7.

Will I lose assets because of the bankruptcy filing?

If you file for Chapter 7 bankruptcy, you can lose any nonexempt assets. However, exempt assets, including those listed above, are protected. Because these accounts are given special protection, you want to think very carefully about refinancing unsecured debt using a home equity loan or a 401(k) loan. You don't want to risk assets protected by bankruptcy laws, as these assets are protected for a reason.

If you file for Chapter 13 bankruptcy, you shouldn't lose any of your assets, because it's not a liquidation bankruptcy. However, if you have secured debt you owe, Chapter 13 typically does not allow you to erase or reduce this debt and still keep the underlying asset.

If you have a home with a mortgage on it or a car with a car loan on it, you're going to have to become current and pay back what you borrowed in full -- in almost every case for both Chapter 7 or Chapter 13 -- or you could lose the asset to foreclosure or repossession. We'll talk more later about exactly how the different chapters of bankruptcy treat mortgage and car loans.

Is my debt dischargeable in bankruptcy?

Some kinds of debt are not dischargeable -- which means bankruptcy can't really solve problems with these debts.

In general, it is difficult or impossible to discharge:

  • Student loan debt: Unless you can meet very specific requirements to prove your student loan debt is an undue burden, you can't discharge it. Most courts apply a test called the Brunner test or a similar test. This test requires you to prove extenuating circumstances (such as a permanent disability) have made paying off the loans such a hardship that you cannot repay your loans and maintain a reasonable standard of living. You also have to show the circumstances will continue to make repayment a hardship for the term of the loan and that you made good-faith efforts to try to repay what you owe.
  • Unpaid child support debt or alimony owed to a former spouse in connection with a separation agreement: In some cases, if you can show that the alimony payment was part of a division of property, the court may allow discharge. And if the supported spouse assigned the right to the alimony to someone else (e.g., designated someone else to receive the funds), it may be dischargeable.
  • Fines, penalties, and restitution owed for criminal acts: There are limited exceptions to this general rule if a fine was intended to recompense the government rather than imposed as a punishment.
  • Civil judgments resulting from death or injuries in drunk driving cases: If your insurance doesn't pay the full amount you're ordered to pay if you injure or kill someone while driving drunk, you typically cannot discharge any resulting debt in bankruptcy.
  • Some types of tax debt: Some types of tax debt, such as payroll tax debt, aren't ever dischargeable. Income tax can be discharged only under certain conditions, such as when you filed a tax return, the tax return was due at least three years prior to the bankruptcy, and at least 240 days have passed since the IRS assessed the tax debt, if the debt was assessed. Even when tax is discharged, the bankruptcy doesn't typically eliminate a federal tax lien on property.

However, there are also many types of debt you typically can discharge in bankruptcy, including:

  • Credit card debt
  • Unsecured personal loan debt
  • Medical loan debt
  • Most debts arising from court judgments and from car accidents
  • Past-due utility bills
  • Deficiency balances from car repossessions
  • Contractual obligations, including leases

You can only discharge these debts if they were incurred prior to filing for bankruptcy. And a creditor can object to the discharge if the creditor proves you got credit under false pretenses; if you bought expensive items or took out a cash advance within 90 days before filing bankruptcy; or if you used your credit card to pay nondischargeable debts, such as charging a big student loan payment.

How are cars, houses, and other secured debt treated in bankruptcy?

As mentioned above, you also typically cannot discharge secured debt, such as mortgages or car loans, and keep the asset.

If you want to keep your home or vehicle, you may have to reaffirm your commitment to pay, or you may be required to redeem the loan by getting current and making payments if you are currently behind.

You can also try to negotiate with your lenders to get them to agree to a lower payment. If you have a car with a loan and have filed Chapter 7, for example, you'd have to turn over the car if you can't or won't pay the loan. But you could ask the creditor to reduce some of the interest or fees you owe in exchange for you agreeing to keep the car and pay under the terms of the new payment plan.

There are also limited exceptions to this general rule that you can't wipe out secured debt in bankruptcy and keep the asset. These exceptions generally apply only under Chapter 13 and are called cramdowns or lien stripping. However, a small minority of states allow lien stripping in a Chapter 7.

Cramdowns or lien stripping

A cramdown can occur if the asset serving as collateral is worth less than the value of what you owe. If you have an investment property worth $150,000 and you have a $170,000 mortgage, the secured loan balance could be reduced to the amount the property is worth -- $150,000. This can also happen on vehicles you owe more on than the car is worth, but only if you purchased the car 910 days before the bankruptcy.

Unfortunately, you cannot do a cramdown on your primary home. However, another process called lien stripping is possible if you have a second mortgage or home equity loan or line of credit. Lien stripping occurs when debt that is classified as secured debt -- but that isn't actually secured in reality -- is recharacterized by the court as the unsecured debt it really is.

Say you have a home worth $200,000, you owe $210,000 on your primary mortgage, and you also have a second mortgage on the house worth $50,000. The second mortgage claims to be secured by the home -- but in reality, if the second mortgage lender foreclosed, the lender would get nothing because all the funds from the home's sale would go to the first mortgage.

In this case, the court could strip the lien from the second mortgage and declare it's actually unsecured debt that could be included in a Chapter 13 repayment plan. This would mean you wouldn't have to repay the second mortgage in full in order to keep the home. The lender can challenge the value of your home, though, and if it is found that the mortgage is partially secured by the house, you cannot strip the lien.

Is there another way I can pay back my debts?

Before you decide to file bankruptcy, it's important to make sure you really can't repay what you owe. Bankruptcy is a big deal, and you shouldn't file if you could potentially avoid it by paying your debts.

If you have some available cash to repay your creditors, and if you don't owe so much that it will be impossible to pay back what you owe, then your alternatives to bankruptcy include:

  • Refinancing your debt to a lower interest rate: This could make monthly payments more affordable and reduce the total cost of repayment. Ideal ways to refinance include personal loans and credit card balance transfer offers. It's a big risk to refinance to a home equity loan or to take a 401(k) loan to refinance your debt, because then you're putting assets that would be protected in bankruptcy at risk.
  • Living on a tighter budget or picking up extra work: If you can increase your income or decrease your spending, you may find you can repay your debt even if you thought doing so would be difficult. This may mean making drastic changes, such as getting a roommate to help with mortgage costs or selling your car and getting a cheaper one.
  • Instituting a debt payoff plan: Approaches such as the debt avalanche and debt snowball have helped many people to pay off large sums of debt.
  • Talking to your creditors: Creditors may be willing to let you temporarily pause payments, or put your loan into forbearance, if you have a temporary hardship. Many creditors want to work with you rather than have you fall behind or declare bankruptcy.

If you can't pay the minimums or your debt balances are so high that monthly payments only cover the interest, it may not be worth trying to repay what you owe. You'll end up enriching your creditors by making payments for many months or many years and not reduce your balance at all.

What alternatives to bankruptcy do I have if I can't pay back debt?

If you can't pay what you owe in full, consider debt settlement -- negotiating an agreement in which your creditors accept reduced payments on your debt. Often, the agreement involves paying a lump sum and the creditor forgiving the remainder of your debt.

Creditors are not typically willing to settle debt if you've been paying on time. They typically only settle if they fear you'll file bankruptcy. There are debt-settlement companies that promise to negotiate with your creditors for a fee, but you can talk to your creditors on your own and save the money.

Debt settlement hurts your credit but not as much as bankruptcy. It can be a better solution provided you have the funds to pay something and can come to a reasonable agreement with your creditors. If you reach a settlement agreement, don't send payment until you have the agreement in writing

You can also speak with a nonprofit credit counselor about what options you may have for dealing with your debt. In general, credit counseling is required within 180 days of a bankruptcy filing anyway, so there's no harm in talking with a counselor. The credit counseling service you must use before bankruptcy has to be approved by the courts. You can find a list of approved counseling services here.

What do I have to do before filing for bankruptcy?

As mentioned above, you're typically required to get credit counseling from an approved credit counselor within 180 days of filing for bankruptcy. You are also required to undergo debtor education after filing.

You also cannot have a very recent bankruptcy on your record, or you will not be eligible to have your debts discharged again. While you can file a second time, it will typically not make sense to do so if you can't get your debt discharged:

  • If you filed for Chapter 7 in the past, you must wait seven years before you're eligible for another bankruptcy discharge through Chapter 7.
  • If you filed for Chapter 7 in the past, you must wait four years before you're eligible for discharge through Chapter 13.
  • If you filed for Chapter 13, you must wait two years before becoming eligible for another discharge through Chapter 13.
  • If you filed for Chapter 13, you must wait six years before filing for a Chapter 7, unless you paid back at least 70% of your creditors under your payment plan and made your best efforts at repayment as part of a good-faith payment plan.

Although not required, it's also a good idea to talk with a lawyer before you file to make sure you complete all your bankruptcy forms correctly, as you don't want to make mistakes such as leaving off creditors and not having all your debt discharged.

What are the pros and cons of bankruptcy?

It's important to carefully evaluate all of the pros and cons of a bankruptcy filing. Here are some of the big advantages to consider:

  • You stop negative information from being posted on your credit report. If you have maxed-out credit cards or aren't paying your bills, you're continually getting negative info posted on your credit report. If you file bankruptcy, you stop this.
  • You stop collections activities. You can end wage garnishment, stop collections calls, and even temporarily pause foreclosure or repossession.
  • You get leverage with creditors. Creditors may become much more willing to negotiate a settlement or a repayment plan if you've filed bankruptcy.
  • You can protect important assets. You don't put your home or retirement accounts at risk when dealing with your debt.
  • You can get a fresh start. If you're in too deep a hole to dig out of, bankruptcy gives you a chance to rebuild.

But there are also some big downsides:

  • Bankruptcy is very damaging to your credit. It will be difficult to get approved for new credit for several years after a bankruptcy.
  • Bankruptcy is personally and emotionally difficult. Many people struggle with bankruptcy because of the stress of court proceedings, guilt at feeling they aren't fulfilling their obligations, or embarrassment at having to seek the court's help with debt.
  • Bankruptcy can lead to the loss of assets. You may have to give up money or property in a Chapter 7.
  • Bankruptcy can necessitate a commitment to a long-term repayment plan. If you file Chapter 13, you'll have to fulfill your repayment plan over many years.
  • You'll have to pay to file. You will have to pay court costs and attorneys' fees -- so your bankruptcy can end up costing several thousand dollars.
  • You may still be left with some debt. If your debt is not dischargeable or if you want to keep secured assets, you will still owe money to at least some of your creditors.

You'll need to weigh these pros and cons and evaluate whether the advantages outweigh the disadvantages.

How will bankruptcy impact my credit and my financial future?

Chapter 7 bankruptcy remains on your credit report for 10 years, while Chapter 13 bankruptcy remains on your report for 5 years.

According to myFico, a bankruptcy can send a 780 credit score down to 540 to 560 and can send a 680 score down to 530 to 550. This is a very low credit score, and most conventional lenders will not be willing to give you a credit card, auto loan, personal loan, or other type of financing.

However, this doesn't mean you don't have options. You can get a secured credit card quickly -- in most cases immediately after a bankruptcy discharge. A secured credit card requires you to pledge collateral. For example, you may have to put $200 in a savings account held by the creditor, and then you will be extended a $200 credit line.

Once you get a secured card, you can start making small purchases and paying on time each month. This can help you build up a positive payment history again. As time passes, the bankruptcy will have less of an impact on your credit score, and your score will go up. Eventually, you'll be able to access other types of credit. You could also gain access to credit with cosigners if someone is willing to share responsibility for debt repayment with you.

And if you want to buy a home, you can typically qualify for an FHA loan as soon as two years have passed after a Chapter 7 or one year after a Chapter 13.

Consider bankruptcy carefully

Bankruptcy is a big deal, but it can provide important relief from debt. Carefully consider the impact of bankruptcy on your debt, along with the pros and cons of a bankruptcy filing, before you decide whether bankruptcy is right for you.

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