4 things everyone gets wrong about bankruptcy

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Hanna Horvath, CFP®

Hanna Horvath, CFP®

Managing Editor & Certified Financial Planner™

Hanna Horvath, CFP®, is a certified financial planner and former managing editor at Policygenius. Her work has also been featured in NBC News, Business Insider, Inc. Magazine, CNBC, Best Company, and HerMoney.

Published October 18, 2019 | 4 min read

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Bankruptcy can be a nefarious term. When you think of someone declaring bankruptcy, this may be the first thing that comes to mind.

But there’s more to bankruptcy than just declaring it.

“There used to be tremendous stigma to it. But it typically isn’t a choice,” said Glenn Downing, certified financial planner and founder of CameronDowning. “Bad things happen to good people.”

Bankruptcy is often not the result of a personal failing. Many are caused by medical debt.

There are plenty of other misconceptions about why you would declare bankruptcy and what the process involves. Here’s what you may not know about it.

So what exactly is bankruptcy?

There are two types of personal bankruptcy: Chapter 7 and Chapter 13.

Chapter 7 bankruptcy is for those with unsecured debt, like credit card debt, medical bills or other types of loans. It’s for those who don’t have the income to pay back the debt, said Karra Kingston, a bankruptcy lawyer in New Jersey. Most unsecured debts are forgiven with Chapter 7 bankruptcy.

Chapter 13 bankruptcy is for those who have a higher income but too much debt. Small business owners file for this type of bankruptcy. They have secured debts they want to keep hold of, like a mortgage, said Kingston. Once you file for Chapter 13 bankruptcy, your debts will be restructured into a three- to five-year payment plan.

Filing bankruptcy is a complex process. Here are some common myths, debunked.

1. Bankruptcy will ruin your life

While bankruptcy can affect you financially, it won’t ruin your life forever. You may think filing for bankruptcy means losing your home and car, but typically you’re able to keep a lot of your possessions.

“It’s a chance to start over,” said Kingston.

In Chapter 7 bankruptcy, debtors will figure out their basic assets, called exemptions, which they are allowed to keep throughout the filing process. These include your home and car. In Chapter 13 bankruptcy, you can keep all of your assets, but must form a plan to pay off your debts over a set period of time. Each state has different laws regarding bankruptcy, so it’s important to talk to a lawyer before filing.

2. You will never be able to buy anything ever again

Once you file for bankruptcy, it will appear on your credit report, but not forever: seven years for Chapter 13 bankruptcies and 10 years for Chapter 7 bankruptcies.

“That means you can get a mortgage,” said Downing. “You can typically get one within a couple years of filing. It may not be the most ideal rates, but it’s still possible.”

Kelly said some credit card companies will specifically offer credit cards to those who recently underwent bankruptcy because they have no debt anymore.

3. All your debts will be forgiven

While you likely won’t lose everything in bankruptcy, your debt also won’t magically disappear. Any court-ordered payments (think taxes or child support) won’t be forgiven.

But other types of debt, like credit card debt, car loans or medical bills, may be forgiven. Working with a bankruptcy lawyer will help debtors understand what they owe.

“You may not need to pay everyone back, only licensed creditors,” said Kingston. “You can catch up on other payments this way.”

4. Paying off your debt is always the better option

While trying to pay off the debt yourself is a good first step, there are times where it’s better to declare bankruptcy.

“If you can’t pay make ends meet or pay your bills, filing would be the best idea,” said Kingston. “If you keep going deeper, you should speak to an attorney. I do not recommend getting loans to pay off your debt.”

Bankruptcy makes financial sense in certain situations, like with new business ventures. Without the potential protection of bankruptcy, individuals may not be as willing to take the financial risk of starting a new business.

“I see bankruptcy as a protection measure which also pushes individuals to take a leap of faith in starting a business,” said Sterling Neblett, certified financial planner and partner at Centurion Wealth Management. “No one plans life with an intention to file for bankruptcy, but if it's a necessity, there is an option to rebuild rather than never get off the ground again.”

You should take the proper steps to avoid filing in the first place. Use a budget to keep track of spending and make sure you’re living within your means.

“You can’t plan for everything in your life,” said Kingston. “But you can try to stay prepared.”

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Image: Aaron Sollner