The term bankruptcy often carries negative connotations. And it is true that bankruptcy filing generally implies some sort of financial hardship. However, bankruptcy is fundamentally intended as a form of protection for those struggling with debt. This includes individuals and businesses.
It goes without saying that bankruptcy filing should be a last resort. Bankruptcy filing is designed to provide debt relief for those who are unable to meet their financial obligations. For Americans who are struggling with the pressure of excessive medical bills, tax debts, or credit card debt, and who are unable to pay creditors, filing bankruptcy can provide some alleviation.
However, filing for personal bankruptcy isn’t quite as simple as that. You may find relief from your obligations. But bankruptcy filings can carry significant long term financial implications for you and your family. In reality, this is a decision you will need to make with the help of a bankruptcy lawyer. Bankruptcy laws can be complex, and it may even be possible that there are other options for debt relief that might better suit your situation.
As we said, filing bankruptcy should be seen as a last resort.
So before you reach that decision, it may help to gain a basic understanding of personal bankruptcy and how it works. Before you file bankruptcy, make sure you’re clear on what this means and how it will impact your financial life in both the short and long term.
If you’re struggling with credit card debt and you’re weighing all of your options, check out our tips on how to pay off your credit cards. Otherwise, read on to see what happens when you declare bankruptcy, for better and worse.
What is bankruptcy?
Bankruptcy is, broadly speaking, an arrangement in which an individual or business with debt receives both debt relief and protection from debt collection in exchange for certain conditions which may including liquidation of assets, reorganization of assets, and/or settlement and repayment of debts.
In the vast majority of personal bankruptcy cases, we are referring to a form called Chapter 7 Bankruptcy. The informational website for the United States Courts identifies this as the single most common form of bankruptcy.
Chapter 7 bankruptcy is based on the liquidation of assets, though some of your most important assets such as home or vehicle may be protected from seizure. This liquidation is done to help pay off your creditors while simultaneously discharging your debt.
Another common form of personal bankruptcy filing is Chapter 13, which instead reorganizes your assets while providing a monthly payment plan commensurate with your earnings and ability to pay. Failure to satisfy your obligations to this repayment plan over the requisite three to five years could subsequently result in liquidation of assets.
How does filing for personal bankruptcy work?
In the simplest of terms, bankruptcy filing is designed to help people who have debts that they are unable to pay. While the term “bankruptcy” carries ominous overtones, its protections are often the best and only option for those who find themselves in difficult financial positions.
Of course, nobody wants to file bankruptcy, but bankruptcy law is designed to help those who have been confronted with an unforeseen financial crisis such as a costly divorce, a prolonged medical emergency, job loss, or loss of the ability to work.
Technically, bankruptcy filing is an agreement you enter into with the federal government. But the process of filing begins with your local bankruptcy court.
The U.S. Courts website notes that “A chapter 7 case begins with the debtor filing a petition with the bankruptcy court serving the area where the individual lives or where the business debtor is organized or has its principal place of business or principal assets.”
Your case is then passed to an appointed bankruptcy trustee. The trustee’s job is to liquidate any nonexempt assets within your estate so that your creditors can be repaid. In exchange for this agreement, you will typically be exempt from any action in pursuit of debt on the part of your creditors.
As an article from debt.org explains, the stigma surrounding bankruptcy suggests some misunderstanding of its purpose. Bankruptcy is not a punishment, but a measure of recourse for those in debt.
That said, the reason for the misunderstanding may stem from the very real consequences that can come with bankruptcy. Indeed, this is not a decision to be taken lightly, nor without exhausting all other suitable options first.
Reasons To File Bankruptcy
There are a number of reasons why a person might consider filing bankruptcy. But having significant debt is not, by itself, a reason to do so.
Typically, this debt will be combined with one or two other circumstances related to your income and assets in order to render bankruptcy a suitable or sensible action. Below are a few of the basic circumstances that might warrant filing for either Chapter 7 or Chapter 13 bankruptcy:
- Your debt liabilities are greater than both your assets (what you own) and your income (what you earn).
- You are seeking protection from aggressive collections efforts, legal actions, liens on property, and more.
- You’ve exhausted all other options such as negotiating with creditors and consulting a credit counselor.
This last point is especially important. As we have and will stress throughout, bankruptcy carries serious consequences. Therefore, before you make this decision, it will be essential to explore all other options first.
With that in mind, it’s important to understand the pros and cons of bankruptcy filing.
The Pros of Filing Bankruptcy
In spite of the ostensibly negative connotation of the term bankruptcy, the article from debt.org points out that the vast majority of those who apply for and receive bankruptcy filing status benefit from its inbuilt protections. According to debt.org, “a 2018 survey by American Bankruptcy Institute showed that 93% of Chapter 7 applicants were able to protect all their assets, including home and car, as long as they were able to make on-time payments.”
In fact, while loss of certain property may be possible, research finds that most people who file for bankruptcy and continue to meet their obligations under the terms of this filing get to keep most of their property. But outcomes vary from case to case. We’ll explore this a bit further in the section below. But first, a look at the benefits of bankruptcy filing.
1. Automatic Stay
In most cases, those filing bankruptcy will be facing significant pressure to repay debts through collection efforts, harassing phone calls and letters, and language threatening the seizure of property and future income.
Whether you are ultimately approved for bankruptcy status or not, just filing for this status will put an immediate stop to all of these actions.
According to Debt.com, “When you file for bankruptcy, it initiates an automatic stay. This means that creditors, lenders, and (best of all) debt collectors can’t contact you. They can’t attempt to get payment or call to harass you once you file. If they do, you can fight back and potentially be compensated.”
For most borrowers who struggle with debt, these threatening collection efforts can be emotionally taxing, adding another layer of anxiety to an already distressing financial situation. While bankruptcy filing certainly carries its own stress, you will at least be in a position to focus on your obligations without distracting or distressing phone calls and letters.
2. You Will Receive Direct Support
Your case is referred to a court-appointed representative. This representative will work directly with you through every step in the process. While this individual will be working to help remedy those to whom you owe money, this representative also functions as an advocate for you.
In other words, you won’t be forced to navigate the complex realities of bankruptcy filing alone. You’ll receive guidance on the best steps forward for your particular case and you’ll gain access to somebody who can operate on your behalf as you resolve your financial difficulties.
According to an article from Lending Tree, “Once you file your petition for bankruptcy, you’ll be assigned a trustee who will see your case through to discharge. They will operate on your behalf throughout the process, including handling all communication between you and your creditors, and in the case of Chapter 13 bankruptcy, they will be the one to receive and process your payments.”
Remain in close contact with this individual as you work through your debts, liquidate assets, and especially as you confront any bureaucratic, logistical or legal challenges during the filing, liquidation or repayment processes.
3. You Will Be Insulated From Legal Action
Lingering debts such as unpaid taxes or medical bills can lead directly to legal action. When you file bankruptcy, you are immediately exempt from legal action in pursuit of those debts.
The article from Lending Tree explains, “One of the largest benefits of bankruptcy is that you could be legally cleared of responsibility for your debt. On top of that, it could potentially prevent any future legal trouble related to the nonpayment of that debt. Keep in mind that not all debts are dischargeable, but most forms of unsecured consumer debt can be wiped out in bankruptcy.”
When this happens, it also wipes out any legal recourse for your creditors, lenders, or collectors. Bankruptcy status means you can’t be sued for the repayment of your debts nor can your creditors use your obligations to place a lien on your property.
This makes bankruptcy a particularly appealing option for those who are facing imminent legal consequences for debt and who lack the resources to otherwise manage these consequences.
4. You Can Keep Your Future Wages
In addition to protecting against the prospect of future legal action, your status also gives you insulation against wage garnishment. That’s because, in most bankruptcy cases, your future wages are not included as part of your settlement. This means that you can continue to earn your full income even as you manage bankruptcy status and liquidate certain assets.
As Forbes explains, “Wages earned after your bankruptcy filing aren’t considered ‘property of the bankruptcy estate,’ meaning your future earnings cannot be garnished to repay creditors for any discharged debt. However, your future wages may still be vulnerable to undischarged debt, like back child support or earnings committed in a payment plan for Chapter 13.”
In other words, this possible benefit does depend on both the kind of debt you have and the kind of bankruptcy status you receive. For those with Chapter 7 status who are effectively able to discharge all debts, future wages will not be taken into consideration as part of repayment.
5. You Will Receive Plenty of Credit Card Offers
As we will explore in the section below, the impact of bankruptcy on your ability to borrow is generally not great, at least in the short- and mid-term. If you do qualify to borrow, you should be prepared to receive less than ideal terms.
That said, you will get no shortage of opportunities to begin rebuilding your credit. You will quickly find that credit card issuers are quite eager to get you back in the game.
Proceed with caution.
The reason you will receive so many offers is because a large number of these will carry high fees and APRs. Some predatory credit card issuers and lenders will line up to take advantage of your situation.
Upsolve advises, “You’ll get more credit card offers right after filing your bankruptcy than you’ll know what to do with. Not only will this help you rebuild your credit and increase your credit score, but it will also give you access to the safety net. If you choose to accept any of these credit card offers, a secured credit card can be a good place to start to rebuild your credit.”
With a secured credit card, you’ll make an initial deposit equal to your spending limit, which works as collateral for any debt you amass. The primary purpose is to help reestablish your credit rating. And the benefit is that you won’t get raked over the coals by high interest rates or hidden fees.
The Cons of Filing Bankruptcy
While there are clear benefits that come with a bankruptcy filing, there are a few critical reasons that we’ve cautioned against using these options as anything other than a last resort.
1. You Are Not Guaranteed Approval
First and foremost, you should be aware that you will have to meet certain conditions first. According to Debt.org, approval for bankruptcy filing is based on a test which is used to determine whether or not you actually have the financial ability to repay your debts without bankruptcy protections.
In other words, it isn’t a foregone conclusion that the bankruptcy court in your locale will accept your bankruptcy petition.
Debt.org explains that “There is a means test required for debtors currently making over a monthly limit. If you make more than the median monthly salary of your state, then a means test is required to determine if you’re truly in a position that calls for bankruptcy. If the court finds that you make too much to file for Chapter 7, your case may be converted to Chapter 13 or dismissed.”
Having your case dismissed would be more than just a major inconvenience. It would also come with an inherent cost.
2. Bankruptcy Filing Costs Money
Even though bankruptcy is meant as an option for those who are struggling with financial hardship, it does cost money to file. In most cases, just submitting the application to a bankruptcy court will cost several hundred dollars. And of course, as noted directly above, there is no guarantee that your application will be approved.
This is why many applicants will seek guidance from a bankruptcy lawyer. Naturally, a bankruptcy lawyer’s services can add a great deal more to your application expenses, possibly even several thousand dollars more.
According to Investopedia, “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.”
If this attorney is the literal difference between your eligibility or rejection, it may simply be worth the cost. But once again, this is a factor you must consider as you decide whether or not bankruptcy filing is the right move for you.
3. You Can’t Discharge Every Kind of Debt
Another major consideration is the exact kind of debt you have. That’s because bankruptcy protections don’t apply to your debts universally. While credit card debts, business debts, medical bills and private loans are usually eligible for discharge under bankruptcy filings, the same is not necessarily true of all debts.
According to Debt.com, “There are certain debts that almost never get discharged, such as back child support or alimony. Tax debt is also not easily discharged, although it depends on the type of tax debt and your situation.”
Another tricky type of debt is student loan debt. It isn’t necessarily impossible to discharge student loan debt through bankruptcy but there are certain exemptions. If student loan debt forms a significant portion of the debt from which you are seeking relief, this may be another situation in which you would want to consult a bankruptcy lawyer. Make sure you understand all of the loopholes that apply to you before you create your bankruptcy petition.
Likewise, make sure you understand which of your debts are unlikely to be discharged. The balance between debts which can and can’t be discharged may be a major determinant in whether or not bankruptcy filing is right for you.
4. Your Credit Will Be Badly Damaged
You also have to strongly consider how this decision will impact your credit rating.
This is one of the major tradeoffs that comes with a bankruptcy filing. No matter how you slice it, this is going to hurt. Your credit report will reflect this negative event. Indeed, bankruptcy is one of the most persistent negative marks on your credit report and will be reflected on your credit score for an extended duration.
A filing for Chapter 13 bankruptcy will stay on your credit report for a minimum of 7 years. A Chapter 7 bankruptcy could be reflected on your credit report for up to 10 years. This negative mark would likely have a tangible impact on your financial life.
According to Investopedia, either form of bankruptcy filing “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.”
Unfortunately, there are no real concrete ways to mitigate this impact other than time, patience, and the adoption of diligent spending and saving habits. And if you must file bankruptcy, the takeaway here is that you’ll want to build your financial planning around these limitations.
Be realistic about your ability to borrow or make major loan-based purchases over the subsequent decade. If you are in this situation, you will find it difficult or next to impossible to receive auto or mortgage loans under favorable terms.
You may be able to apply for certain credit cards, but don’t expect the best deals out there. As noted in the section above, you may receive plenty of offers, but few will come with favorable repayment terms. Beware of high interest rates and hidden fees. Alternatively, as we’ve noted above, you might consider applying for a secured credit card in this instance, which could help you rebuild your credit over time.
5. You Could Lose Important Personal Assets
Also as noted above, Chapter 7 bankruptcy is based on a process of liquidation. This means that the bankruptcy trustee assigned to your case will assess the value of your assets. Any of your assets which have not been granted exemption from liquidation may be sold in order to remedy your debts in exchange for discharge of your debts. This could result in the loss of any number of major assets.
According to Investopedia, “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.”
It goes without saying that this can be an extremely painful process, one that can result in its own set of long term hardships. With Chapter 13 bankruptcy, you have protection over a greater portion of your assets. However, you are required to meet certain repayment responsibilities, including full repayment of an agreed upon settlement amount over three to five years. Failure to meet these obligations may ultimately cause the loss of these assets.
Other Options
The U.S. Courts note that there may be other options. Specifically, it notes that there are few advantages to filing for Chapter 13 Bankruptcy in lieu of Chapter 7.
Here, say the Courts, “individual debtors who have regular income may seek an adjustment of debts under chapter 13 of the Bankruptcy Code. A particular advantage of chapter 13 is that it provides individual debtors with an opportunity to save their homes from foreclosure by allowing them to “catch up” past due payments through a payment plan. Moreover, the court may dismiss a chapter 7 case filed by an individual whose debts are primarily consumer rather than business debts if the court finds that the granting of relief would be an abuse of chapter 7. 11 U.S.C. § 707(b).”
The Courts also note that you may have the option of settling certain debts out of court for a lesser sum, or through regular monthly payments, by working directly with your creditor.
You may also be able to enter into credit counseling. In many cases, credit counseling programs may allow you to make manageable monthly payments toward your debt.
***
Speaking of other options, there are plenty of ways to manage your debt that don’t carry the same financial, personal, and legal consequences of bankruptcy filings. For more, check out our comprehensive guide to restructuring, refinancing, and consolidating your debts.