Hitting the Reset Button on Your Finances: Can Filing for Bankruptcy Benefit You?

Have you ever read Oliver Twist? The only tragedy surrounding this book, for most people, is that they’re forced to read it at school. The truth is far darker: it is essentially based on a real-life story. When he was 12 years old, Charles Dickens‘ family was sent to debtor’s prison – a jail for people considered impossible to rehabilitate financially – where they would typically be forced to work in miserable conditions until they either paid off their debts or died.

Going bankrupt, in those times, was seen as a crime no less serious than fraud. Even today, failing to pay a debt means breaking the law in some countries. Dubai airport is famously littered with luxury cars left behind by people fleeing both their creditors and prison; it’s not a bad place to visit if you’re looking to buy a lavish model for cheap.

In America, of course, the consequences of becoming insolvent – being unable to pay your debts now or in the future – are much less serious. There are still some fairly steep penalties to landing in this position and declaring bankruptcy, though. The concepts of credit and accountability would pretty much become meaningless if this weren’t the case. If landlords of underperforming properties could simply duck out of their mortgages whenever they wanted, for instance, everyone from tenants to banks to responsible homebuyers would suffer.

Declaring bankruptcy is therefore supposed to be a last resort. It gives you a way out when no other options are available. It does not, however, wipe your financial slate completely clean, and does major and long-lasting damage to your credit score. This, in turn, makes it much more difficult for future you to get a personal loan, negotiate good rates on anything from insurance to credit cards, or even find a job.

What Exactly Is Bankruptcy?

The basic idea is that a person (or business, though the rules and procedures are somewhat different in that case) who cannot repay his debts approaches the courts to formally confirm this state of affairs. This usually results in the appointment of a trustee to partially manage the insolvent debtor’s finances; it also severely restricts the options creditors have for reclaiming the money they’ve lent him.

The main advantage to the debtor is that he can escape an overwhelming debt burden without losing everything he owns and ending up on the street. Depending on the circumstances and what kind of bankruptcy he applies for (more on this in a minute), some or all of his debt may be canceled. Creditors, while not overjoyed, are generally happy to accept the court’s decision too. It’s better for them to get some of the money they’re owed than nothing; in addition, the involvement of a trustee ensures that the whole process is reasonably fair and streamlined.

These kinds of legal protections are essential in a country, like the United States, with a “boom and bust” mentality and no significant social safety net. It can easily happen that a person’s financial future is ruined by simple bad luck (think medical expenses). Other times, bad judgment may be involved, but allowing failure to become permanent would reduce people’s capacity for risk-taking and therefore innovation. While there’s still some social stigma attached to going bankrupt, it’s seen more and more as a legitimate escape from dire financial straits – over half a million personal bankruptcies were processed in 2020. Many people, perhaps having learned from their mistakes, have gone on to great things after recovering from bankruptcies.

Two Birds Not Quite of a Feather

Technically, Federal law defines half a dozen different types of bankruptcy. Almost all private individuals, however, opt for either Chapter 7 (roughly 70% of all filings) or Chapter 13 (30%). Neither is expressly designed to let you escape all of your debts: you will still be expected to pay back as much as you are able and, as we’ll soon see, some loans remain valid regardless of bankruptcy.

The more popular Chapter 7 is often called a straight bankruptcy or liquidation. If you successfully file for this, the court-appointed trustee will sell some or all of your non-essential assets in order to generate cash with which to pay your creditors. Part of your debt will most likely be discharged (meaning forgiven) and essential, “exempt” goods such as your car, personal effects, pension savings, and tools you need to make a living will not be touched.

Chapter 7 requires you to prove that it’s impossible for you to pay off your debts based on your total liabilities, assets, income, and expenses. Generally, you have to earn less than the median for a family in your state to qualify for Chapter 7. Alternatively, you can present a means test; if you cannot pass (or rather fail) this, you may be asked to consider Chapter 13 instead.

A Chapter 13 application, referred to as reorganization, is much less likely to be granted (approximately 45% as opposed to 95% for Chapter 7). It does not necessarily involve your assets being sold off; instead, you will need to present a payment plan spanning the next 3 to 5 years that results in your debts being paid off. This usually requires you to take a larger share of responsibility, but may also allow you to write off certain debts. Though the terms are less generous than with Chapter 7, Chapter 13 has one major advantage: it doesn’t affect your credit score quite as severely as would otherwise be the case. A Chapter 7 bankruptcy stays on your credit report for 10 years, Chapter 13 only 7.

All Debts Aren’t Equal!

Many people in desperate situations think of bankruptcy as a kind of magic wand that will cure all their troubles. It can certainly bring a great deal of relief, but you should understand that certain debts will follow you to your grave and even beyond – some have to be paid by your estate before your children can claim a dime. If mortgage, credit card, medical, and car payments are driving you into the ground, filing for Chapter 7 or 13 may get you out of the hole, but understand that declaring bankruptcy generally won’t affect the following obligations:

• Child support and alimony,
• Unpaid taxes, especially more recent ones,
• Criminal liabilities awarded against you for willful (but not negligent) damage or injury,
• Debts not declared in the bankruptcy filing,
• Student loans.

The latter point is somewhat controversial; the rationale seems to be that an education is a life-long asset that boosts a person’s earning potential and should therefore be treated differently than a car or a second home.

There is another notable exception in the form of loans taken out while you knew that you were likely to apply for bankruptcy. This provision is clearly intended to prevent abuse of the bankruptcy system and protect lenders from people acting in bad faith. Nevertheless, you can still take out an emergency loan just to cover basic expenses if money is really tight. If this is the case, it’s best to be upfront about the situation in order to retain the goodwill of the trustee and judge overseeing your case.

When to Consider Filing for Bankruptcy

In general, there are two scenarios in which an individual will want to declare themselves bankrupt:

• They absolutely and categorically can’t pay off all their debts; their assets and income simply do not make this possible. Rather than prolong the pain, they’d prefer to start from scratch (Chapter 7).
• They have the money to repay most or all of what they owe but not under the present terms. Perhaps they need an extension or a waiver on some debts; often, they’d prefer to hang on to assets like investments or real estate rather than liquidating these (Chapter 13).

Ultimately, the question of whether either of these circumstances applies will be decided by the courts, not you. If there is no realistic chance of you paying off all your current debt in the next five years, however, the conclusion is likely to be the same. Math works out the same no matter who’s doing it, so start making a list of all your debts, what payments you have to make on them each month, your income, and unavoidable expenses.

Some other signs that bankruptcy may be your only or best choice include:

• You frequently have no money in your checking account while your credit card balance increases month after month,
• Multiple creditors are threatening to sue you and you have no way of appeasing all of them,
• You owe more on your mortgage than you can get if you sell your house,
• You are about to get a divorce,
• You are thinking of taking an advance on your 401(k) retirement account (which would be protected under Chapter 7) just to keep your head above water.

Somewhat surprisingly, only 5% of bankruptcies can be attributed primarily to reckless spending (though it’s certainly a contributing factor in many others). Statistics also show that the majority (almost two-thirds) are the result of unexpected medical bills, with long-term unemployment coming second.

What Is It Like Going Through Bankruptcy?

Many people would describe going through bankruptcy as a strange combination of heartache, embarrassment, anxiety, and finally relief. Dealing with the law in any form is bad enough and having to face certain financial realities can be even worse. On a more positive note, the process is fairly straightforward (at least if you’ve enlisted the services of an experienced bankruptcy attorney) and generally results in a favorable outcome.

The first step is always to go for a credit counseling session. This is mandatory within 180 days before actually filing and may even end up indicating that bankruptcy isn’t your best course of action. Such a counselor will go through your financial situation with you and, if warranted, issue you with a certificate of attendance you have to attach to your petition.

This petition consists mainly of some standard forms accompanied by financial statements laying out your debts, assets, and income. You may prepare these yourself, but it’s a very good idea to ask an attorney to do so. Depending on where you live and how complex your finances are, this may cost as much as $2,000 for Chapter 7 and twice that for Chapter 13. This is money well spent, though, as a professional can navigate several problems which may otherwise delay processing, cause you to lose money needlessly, or have your petition rejected entirely.

Before a judgment can be issued, you’ll also have to sit through a “341 meeting” where your court-appointed trustee and creditors have the opportunity to ask you questions about your finances and your plans, if any, to repay them. This is normally a formality, but objections may be raised if it appears that you are committing bankruptcy fraud. If, for instance, you’ve attempted to hide assets or sources of income, your petition may be rejected in addition to criminal charges being laid against you.

As long as everything is in order, it’s unlikely that you’ll even have to see the judge, who generally rubber-stamps petitions approved by your trustee (who works for the Department of Justice, not you). You will, however, have to complete a course on money management before your debts are actually discharged – probably a good idea as this will help you avoid the same situation from arising in future.

Chapter 7 proceedings usually take about four months to run their course, after which you’ll be free to begin your new, largely debt-free life. With Chapter 13, you’ll have to be diligent in sticking to your repayment plan for the next 3 to 5 years but should at least find your finances under much less strain.

The Consequences of Bankruptcy

If declaring bankruptcy were all roses and no thorns, everybody would be doing it. Of course, this isn’t so. For one thing, you should keep in mind that bankruptcies are a matter of public record. If this could affect you later in life (perhaps you’re planning a career in politics?), you may want to explore other alternatives first.

You May Have to Cut Back on Your Lifestyle

The majority of people filing for bankruptcy aren’t exactly rich. On average, the annual income of people seeking Chapter 7 is only a shade over $30,000, while Chapter 13 applicants clock in at about $40,000. At these income levels, there usually isn’t a ton of wiggle room in terms of how you organize your finances. Still, conversely, there’s a good chance that your spending habits are (at least partly) what brought you to this place to begin with. If you haven’t before, you will have to draw up a household budget and see where you can save money each month.

The good news is that filing for bankruptcy won’t cause you to lose your home – as long as you can keep up with the payments, that is. The purpose of bankruptcy, after all, is to help you get back on your feet, not punish you indefinitely for something that may not have been your fault.

Rebuilding Your Credit Score Takes Time

Your FICO credit score will generally drop by between 100 and 200 points the moment you’re declared bankrupt. This remains on your record for 7 years for Chapter 13 and a full decade under Chapter 7; this and the implications thereof are the greatest single drawback of filing for bankruptcy.

Chances are that you’re now more leery of taking on debt, so you may think that a lower score shouldn’t matter too much. Unfortunately, a variety of companies use your credit score as a gauge of your general level of responsibility, so you may well have trouble:

• Landing a new job,
• Getting affordable insurance,
• Leasing an apartment,
• Achieving a government security clearance.

Loan Co-Signers Will Still Be on the Hook

One wrinkle in bankruptcy law is that, while you may be discharged from a debt someone else signed surety for, they are still liable for the full amount. This is, indeed, why many credit providers prefer that people with poor credit find someone to co-sign a loan with them. You may try to reimburse them privately, but remember that money troubles have ruined more relationships than politics, practical jokes, and supporting opposing football teams ever did.

Alternatives to Declaring Bankruptcy

Filing for bankruptcy isn’t the end of the world, but it’s still a pretty drastic step. Once you go there, you can’t come back. In addition, it’s not a measure you can use whenever you want: at least 8 years have to elapse between Section 7 bankruptcies (although you can file for a Section 13 in the meantime).

Let’s look at some things you may want to try before you dent your credit score for years to come:

Re-Evaluate Your Budget

Pretty generally, people think that they work longer hours than the clock says, watch less TV than they really do, and spend less on impulse purchases than their credit card statement suggests. Actually measuring these factors usually leads to some surprises – we are just bad at estimating things, including finances, on gut feelings alone.

If you work at it, you can almost certainly find a little extra money to keep up with your debt payments by cutting stuff you don’t really need out of your life. Assessing what you spend each month, finding cheaper alternatives, and drawing up a personal budget is hard – especially if you need to communicate with a spouse or family as part of the process. It is, however, essential if you hope to avoid having to file for bankruptcy.

You’re going to have to do pretty much just this in order to prepare your case for bankruptcy as well as once it’s been granted, so why not get a head start and possibly short-circuit the whole process?

Go to Credit Counseling

Credit counseling is another mandatory part of bankruptcy proceedings you can get the jump on. The basic idea is to talk to a financial planning expert about your current situation and ways of escaping it short of accepting Chapter 7. If there really is no better option, you’ll probably want to know about it as soon as possible, but it may also be possible to devise a less radical solution.

If you’re having trouble keeping up with your various payments, a counselor may suggest a debt management plan which will hopefully enable you to get out of the red within less than five years. This will often involve having the credit counseling company dealing with creditors and paying your bills on your behalf, leading to lower monthly payments, reduced interest rates, and putting an end to collection calls.

Depending on which organization you choose, the initial consultation may be free of charge. Your go-to resource for finding a trustworthy counseling service is the nonprofit National Foundation for Credit Counseling.

Negotiating a Debt Settlement with Your Creditors

One reason creditors accept their debtors going bankrupt is because, by law, they have to. The other is that they know that some people simply cannot afford to pay them back in full, and getting a little bit is better than nothing.

Short of Chapter 7 bankruptcy, this arrangement is called a debt settlement: paying a lump sum in exchange for the rest of the debt (usually between 50% and 90%) being forgiven. You may need to sell an asset in order to come up with this money but will no longer have to worry about interest and late fees piling up. These discounts may seem large, but they do make sense: debt collection companies often buy up overdue debt for pennies on the dollar, so they can still make a profit without receiving the full amount.

A company is under no obligation to accept a settlement offer, and this is usually considered only for debt that is well past due. You can try to negotiate this yourself or use the services of a company specializing in this kind of debt relief. Fees are high – up to 25% – but this route may still end up costing less than full bankruptcy. In addition, your credit score will be negatively impacted and you may face tax implications, so it’s worth discussing the possibility of debt settlement with a credit counselor before you rule out filing for bankruptcy.

Other options you can explore are to renegotiate one or more of your debts for a longer term or lower interest rate, asking for forbearance (being allowed to stop making payments for some amount of time), or refinancing. Even the much-feared IRS is willing to work with people who can’t pay their full tax burden, or at least not all at once.

Take Out a Debt Consolidation Loan

Having lots of debt, by itself, usually isn’t a good reason to declare bankruptcy. The real problem arises when this debt continues to grow: keeping up with interest payments alone can strangle your cash flow without making a dent in what you owe.

Unsecured debt (i.e. that taken out without collateral), like medical bills and credit card balances, typically carries very high interest rates. The outstanding amount may grow by 20% or more per year. Taking out a loan at (for example) 10% to pay off all your high-interest debt instead saves you money. In addition, loans designed specifically for consolidating debt run over longer periods, meaning that your monthly payments will be lower.

The bad news is that you’ll need a credit score of at least 650 to qualify for a good interest rate on one of these consolidation loans. If you have poor credit, it may still be worth seeing for which products you qualify: at the very least, consolidating your debt reduces the number of creditors annoyed at you to one, leading to fewer harassing phone calls.

Declaring Bankruptcy Is Always Painful

Deciding to file for bankruptcy should be seen as choosing the lesser of two evils, not a quick fix for a situation you can still get out of. It’s a fresh start, not a free pass.

Done right, it can prevent your finances from gradually going downhill. It can also hit the reset button if, through some unexpected disaster not of your making, your liabilities end up exceeding your assets by a large margin. It’s important to get help with figuring out whether Chapter 7, Chapter 13, or perhaps some less drastic action like a debt management program will give you the best outcome. Once this is clear, however, you shouldn’t delay. Declaring bankruptcy is never easy, but prolonging things will not make it any easier.

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