When filing bankruptcy is the right (and wrong) choice

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When filing bankruptcy is the right (and wrong) choice

To file for bankruptcy, or not to file for bankruptcy. That may be the question you find yourself asking if you’re staring down a case of insurmountable financial problems, but one that’s ultimately hard to answer.

There’s a serious stigma attached to bankruptcy. It can be expensive, affect your credit, and even harm your reputation or your ability to get a loan, buy a house or car, or get hired for a job.

But bankruptcy isn’t inherently bad. It isn’t the type of thing that should be taken lightly, but as a last resort, it can be the quickest pathway to fixing your issues if you’re drowning in debt.

When should you consider bankruptcy, and when should it be avoided?

What is bankruptcy?

Bankruptcy is essentially the most extreme form of debt relief, a legal process that allows you to rid yourself of outstanding debt and start over again financially. When you’re approved for bankruptcy status by a federal bankruptcy court, some or all of your debts will be forgiven, and creditors and collections agencies are no longer permitted to pursue you for those debts under law.

Most bankruptcy cases are filed voluntarily, and there are two common types: Chapter 7 and Chapter 13. According to the United States Courts, as of March 31 of 2017, there were 124,271 Chapter 7 filings, and 775,122 Chapter 13 cases in bankruptcy court.

Chapter 7 bankruptcy is known as asset liquidation bankruptcy, or simply straight bankruptcy. Here, most, if not all, of your debt is erased. Your debts will be forgiven, and creditors and collections agencies can’t legally pursue you for them any longer; they’re put on what’s called an automatic stay. Chapter 7 bankruptcy proceedings usually take about three to six months to complete, and to be considered for it, your income can’t exceed that of your state’s median income.

Chapter 13 bankruptcy is essentially a repayment plan. It’s not asset liquidation, but a court-approved readjustment of your debt. Think of it how you would a student loan debt refinance: you arrange for new terms and conditions to make paying off your debt easier. It’s actually almost like a deferment, since it basically puts your debt payments on hold temporarily, enabling you to pull your finances together and resume paying down your debt under a new plan.

Not that you’d want to make a habit of it, but you’re allowed to file for both types of bankruptcy more than once: Chapter 7 every eight years and Chapter 13 every two years.

One side note: Chapter 11 of the U.S. bankruptcy code is known as reorganization bankruptcy; like Chapter 13 for individuals, Chapter 11 is meant for businesses and organizations to restructure their finances to pay off their debts.

When filing for bankruptcy is a good idea

Should you file for bankruptcy? It may not seem like it, but bankruptcy can have a silver lining, and there are actually some times when it’s the right move:

You have large amounts of unsecured debt. Filing for Chapter 7 bankruptcy can work in your favor if you have a significant amount of unsecured debt, like credit card debt, unpaid medical bills, personal loans or business debts. Unlike secured debt, such as a mortgage or auto loan, unsecured debt isn’t backed by property or collateral, so if you’re successfully cleared for bankruptcy, your debt is discharged, your assets are protected, and your debts are even.

You qualify for exemptions. Most examples of Chapter 7 bankruptcy mean erasing your debt in exchange for your assets to pay off the debt. (When you hear of people having their property repossessed, they’ve declared Chapter 7.) However, there are exceptions and exemptions under the law. In some instances, you’d likely be able to keep your car, your home (depending on what state you live in), retirement accounts or pension plans, your clothing and other household items unless they’re of significant value. Having the ability to retain most of your assets and emerge relatively unscathed from a bankruptcy proceeding sets you up for quicker financial success.

Bankruptcy can help you in the long run. You may be in a seemingly no-win situation where you don’t earn enough to pay down your debt, but you earn too much to qualify for Chapter 7 bankruptcy. Chapter 13 bankruptcy makes this a good thing, since the debt repayment structure uses your existing income to determine how much you’re allowed to use for living expenses and how much you’re required to pay toward debt. It’s a proactive tool to dig out of debt and rebuild your finances without taking the extreme measures a Chapter 7 filing can bring.

When declaring bankruptcy is a bad idea

There are times when the cons simply outweigh the pros, and no matter how dire your debt may appear, bankruptcy will only exacerbate the problem. Consider some of these reasons why bankruptcy may not be the best decision:

You have debts that aren’t eligible for dismissal. You may have some debts that a Chapter 7 bankruptcy proceeding will discharge, but if you have too many ineligible debts, it may not be worth the trouble or cost of filing. (The average bankruptcy attorney’s fee is $1,450.) So while you may have some medical debt in collection, bankruptcy won’t do anything for your student loans, back taxes, or alimony or child support costs if your debt was the result of a divorce. In these cases, not only would hiring a lawyer cost you but the majority of your debt would still remain.

You can’t handle the potential consequences. A bankruptcy can remain on your credit report for 10 years, and following a bankruptcy proceeding, your credit score could see a drop of 100 to 250 points depending on the amount of debt and type of bankruptcy filing. If future lenders run a credit check on you, your chances of being approved for a mortgage loan, a new credit card, renting an apartment, or even obtaining an insurance policy at a reasonable rate may be slim to none. Worse still, can you handle losing your assets and belongings? You’ll need to start from scratch to replace them, which will cost time and money. Lastly, think about how it could affect other people; if you have a cosigner on a loan in your name, a Chapter 7 bankruptcy will leave them responsible for footing the bill on any debt you don’t pay down.

You haven’t looked at the big picture. With bankruptcy, be careful what you wish for; you might just get it. You may qualify for a Chapter 7 or 13 filing, but do you really need it? Your financial situation may not be as bad as you think. Have you examined all your alternatives to pay off your debt? If you’ve lost a job, will you receive unemployment benefits, or can you look for side work to raise cash? Can you rework your budget to find a place for your debt? Can you negotiate a payment plan with your creditors without the court’s involvement? Seeking bankruptcy may end up being a permanent outcome to a temporary problem.

Make your decision carefully

Weigh the pros and cons before thinking about bankruptcy. It’s not a reversible decision, and you may find that the grass isn’t greener on the other side of the debt fence. Consider bankruptcy in the most troubling circumstances, like if you have zero income, your house is in foreclosure, or you’re already in legal trouble for past due bills.

Even if your situation is nearly identical to those scenarios, remember to think about your options. Consulting a credit counselor or financial professional -- or simply communicating with your creditors -- may be the ticket to erasing your debt on your own terms.

Image: Matt Brown