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If you're overwhelmed by debt and have exhausted all other options for repaying your creditors, filing for bankruptcy may be your only option. It may even come as a relief. Doing so has significant consequences for your credit and your ability to borrow money in the near future, however, so it's important to weigh all your options before moving ahead.
Bankruptcy is a federal judicial process that protects people in serious debt from being sued or otherwise forced into financial ruin by their creditors. It prevents creditors from pursuing debts, and may erase, or discharge, some debts altogether.
Bankruptcy cannot discharge all debts, however. Depending on the type of bankruptcy protection you qualify for, it also may require you to make full or partial repayment to your creditors and/or demand that you forfeit property that can be sold to help meet your obligations.
What to Consider Before Filing Bankruptcy
Because its consequences can be severe, before filing for bankruptcy it's wise to think through your circumstances and options, perhaps with the advice of a certified credit counselor or qualified bankruptcy attorney. Questions to consider include the following.
Is Bankruptcy Your Best Option?
Bankruptcy has significant negative consequences for your credit, and can hinder your ability to borrow money for years. So before pursuing it, make sure it's the best (or only) option available for tackling your debts. Consider other options besides bankruptcy before you file, such as contacting a credit counselor. A nonprofit credit counselor can help review your income, debts and other expenses and advise on other potential options, including negotiating on your behalf to set up a debt management plan with your creditors.
Do Your Debts Qualify for Bankruptcy Protection?
Bankruptcy can eventually discharge most forms of unsecured debt (credit card balances, unpaid medical and utility bills and the like). Secured debts—those that use property as collateral, such as mortgages, home equity loans and car loans—typically are not shielded by bankruptcy, and the law also excludes these priority debts from bankruptcy protection:
- Alimony and child support payments
- Criminal fines and restitution
- Federal student loan debt
- Certain unpaid taxes
What Assets Should You Try to Protect?
All bankruptcy procedures let you retain a portion of your possessions designated as "exempt" property, which can include real estate you own outright, tools and equipment you use for work, vehicles and personal items. The amount of these exemptions vary by state and, depending on how much you own, they may not cover all your assets.
Furthermore, if you're still making payments on a home or car, bankruptcy may temporarily prevent foreclosure or repossession, but lenders may still eventually seize them unless your bankruptcy strategy prevents it.
Different bankruptcy procedures (more on that below) allow you to shield different assets from forfeiture, so you should prioritize the things you most want to keep and begin strategizing accordingly, keeping in mind that you may not be able to hold on to everything.
Which Type of Bankruptcy Is Most Appropriate for You?
Eligibility for specific bankruptcy procedures (see below) are determined in part by your assets, the extent of your debts, and your income and expenses relative to your state's median levels, as determined by a means test.
Types of Bankruptcy
Federal law provides several categories of bankruptcy protection, applicable to different types of debtors (such as individuals and corporations) and detailed as chapters of the bankruptcy law:
Chapter 7 bankruptcy is also called liquidation bankruptcy because it compels a court-appointed trustee to sell your nonexempt property and use the proceeds to repay your creditors. You get to keep certain exempt assets and possessions, valued up to a limit that varies by the type of asset and its monetary value. When the process is over, the remainder of your dischargeable debts are erased.
Chapter 13 bankruptcy is for individual debtors and couples with sufficient income to make full or partial repayment to their creditors. Also called reorganization bankruptcy, it establishes a schedule of monthly payments lasting three or five years, depending on your income level. If you make all required payments over that time, the court discharges any qualifying debts that remain.
A major advantage of Chapter 13 is that it can enable homeowners who've fallen behind on mortgage payments to get caught up and keep their homes.
How Does Filing for Bankruptcy Affect Your Credit?
A bankruptcy is considered one of the most severe negative entries that can be recorded on a credit report, with deep and long-lasting adverse effects for credit scores for as long as it stays on the report.
A Chapter 7 bankruptcy stays on your credit report for 10 years from the date you file your petition with the court. A Chapter 13 bankruptcy remains on your credit reports for seven years from the filing date.
The appearance of a bankruptcy on your credit reports might not actually reduce your credit score by many points, because bankruptcy typically follows a period of multiple missed payments and other negative events that hurt your scores. Credit scores severely damaged by other events may not drop much further in the wake of a bankruptcy, but they may take longer to rebound than they would without the bankruptcy.
The extent to which a bankruptcy reduces your credit scores will diminish over time, but even if your scores recover after a period of years, some lenders will not even consider doing business with you until the bankruptcy expires from your credit reports.
Alternatives to Bankruptcy
Some alternatives you might consider before filing bankruptcy include:
- Debt consolidation: Using a relatively low-interest loan to pay off multiple high-interest debts is a time-tested strategy, with benefits that include lower interest charges and replacing multiple monthly payments with a single more manageable one. If your credit scores aren't too damaged by missed payments or other missteps, consider researching debt consolidation loans to see if one can improve your circumstances.
- Debt management plan: Seek advice from a certified nonprofit counselor and explore the option of a debt management plan (DMP). The counselor can work with your creditors to help arrange a workable plan for repaying some or all of what you owe. This typically results in closure of your accounts and can leave your credit bruised, but effects are typically less severe and shorter-lived than those of bankruptcy
- Creditor negotiations: Ask your creditors about working out an agreement to reduce your interest rate or lower your minimum required payment. If your debt problems are temporary, your lender may agree to forbearance or a hardship agreement, which can reduce your payments for a period of time while you get back on your feet.
Trying to settle for less than you owe is also an option, but creditors may not agree and, if they do, it will have a greater negative effect on your credit than a full-repayment plan. It's generally better to pay off the debt in full than to seek settlement for less than you owe.
Even if your creditor grants you easier payment terms, their deviation from the arrangement spelled out in your original loan or credit agreement can result in negative entries in your credit reports. Nevertheless, bankruptcy will still have a more significant negative impact on your credit than will credit negotiation, credit counseling and debt consolidation.
When to File for Bankruptcy
Once you have consulted with financial and legal experts and determined you have no other practical alternatives, filing for bankruptcy sooner than later can bring an end to anxiety over crippling debts and your creditors' efforts to collect them. Working with an attorney can smooth the process and ensure thorough, timely submission of all documents required by the court.
Whichever procedures are applicable to you, the bankruptcy process can eventually free you from your obligations and give you a clean slate for rebuilding your credit and your financial life.
The Bottom Line
The decision to file bankruptcy is never an easy one, but under certain dire circumstances it can be the best decision, if not the only one. The road to restoring your credit and financial health after bankruptcy can be a long, challenging one, but millions of Americans have endured it and recovered. You can as well.