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Bankruptcy has long been stigmatized in the United States. People who file for bankruptcy protection have been stereotyped as irresponsible, unethical, or lazy. But many Americans find themselves facing bankruptcy due to an unexpected crisis, such as job loss, medical emergency or divorce.
Bankruptcy is designed to give debtors a fresh start and relieve creditors. But declaring bankruptcy is a complex decision, and while it may be the best path for some, it’s not ideal for all situations.
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Should you file for bankruptcy?
If you’re overwhelmed with debt you can’t pay off, or maybe your mortgage is underwater and you’ve exhausted all other options, bankruptcy filing can be a wise decision.
Keep in mind that the degree of financial assistance you receive in the event of bankruptcy will largely depend on the type of debt you incur. Bankruptcy will not discharge child support debt, most back taxes, or other debts resulting from legal obligations. And, student loan debt is notoriously difficult to service, although the Department of Education recently indicated that it is considering making bankruptcy an option for student borrowers.
A credit counselor can help you assess your current financial situation and determine if bankruptcy is the best solution. Meeting with a credit counselor may be necessary anyway, as anyone filing for bankruptcy is required to receive credit counseling from a government approved agency as part of the process.
You should also consult a bankruptcy lawyer whether to file. A lawyer can advise you on which of your debts can be settled in bankruptcy and whether to file Chapter 7 Bankruptcy (known as liquidation bankruptcy) or Chapter 13 Bankruptcy (known as a reorganization bankruptcy).
If you decide to file Chapter 7, you must demonstrate your eligibility through a means test, which assesses your debt, expenses, and income to determine if you really cannot afford to repay what you owe. .
Advantages and disadvantages of filing for bankruptcy
- Bankruptcy offers a break from creditors. An important benefit of bankruptcy is that it provides temporary and permanent relief to creditors. An “automatic stay” prevents them from attempting to collect money from you while the bankruptcy is pending and provides temporary protection against seizure, eviction, and car repossession. Later, if a debt is discharged by bankruptcy, debt collectors are no longer allowed to collect it.
- It protects future wages. Wages earned after you file for bankruptcy are not considered “ownership of the bankruptcy estate”, which means that your future earnings cannot be seized to repay creditors for any debt discharged. However, your future wages may still be vulnerable to undischarged debts, such as child support or earnings committed to a Chapter 13 payment plan.
- It can bring emotional relief. Juggling creditors can be exhausting, and financial stress can have a big impact on your health and your family. Bankruptcy can give you leeway and a clean slate
- You can keep certain assets. Bankruptcy may require you to sell certain assets to pay off your debts. But you won’t lose everything, because bankruptcy exemption laws protect your home, car, clothes, and other valuables up to the amounts listed below.
Federal bankruptcy exemptions
- Bankruptcy destroys your credit. Your credit score indicates how likely you are to pay off your debts, so bankruptcy can do huge damage to your credit. A bankruptcy will stay on your credit report for up to 10 years, but you can start rebuilding your credit immediately. You can start by removing a secure credit card. If you file for bankruptcy, your credit is probably not in good standing, so the hit to your credit score may not be huge. If you still have decent credit, there may be alternatives to bankruptcy available to you.
- It can be costly. Bankruptcy filing fees range from $313 for Chapter 13 to $338 for Chapter 7. Attorney fees vary but start at $1,300 for Chapter 7 bankruptcy and $3,000 for Chapter 13.
- You may have to give up luxury items. While bankruptcy protects exempt assets, like your home and clothes, a Chapter 7 filing requires that all ineligible assets be sold, to help you pay off your debts. In Chapter 13 bankruptcy, you can keep your assets, but the value of non-exempt luxury assets is used to negotiate a repayment plan with your creditors.
- It will be more difficult to borrow again. Having bankruptcy on your credit report will deter lenders from extending credit in the future. You may not be able to get a loan until the judge clears your debt. If you have filed Chapter 7, you must wait two to four years after your discharge before applying for a mortgage.
Alternatives to filing for bankruptcy
Before a non-exempt asset is liquidated in a Chapter 7 bankruptcy, you may consider selling it yourself. You could get a higher price and use the extra funds to pay off the debt.
Negotiate with creditors
It may seem counter-intuitive, but you can contact your creditors directly. This option works best early in the process before you get too delinquent, but later you can negotiate directly with the collection agency. Explain the circumstances and try to reach an agreement, which could provide you with a lower interest rate, reduced payments, a lump sum payment or a monthly payment plan.
Lenders are often ready to negotiate, because they are likely to recover more money than if you went bankrupt or your account was sent for collection. And debt collectors may be eager to negotiate because they’ve usually bought your debt for pennies on the dollar. Whichever method you choose, be sure to get your consent in writing. Keep a log of your conversations and detailed records of all payments made to your lenders.
You can negotiate on your own or turn to professionals for help. Nonprofit credit counselors can walk you through the process, but they rely on you to contact your lenders. Debt settlement companies, also known as debt relief agencies, will do the talking for you, but often charge high fees, and not all creditors are willing to work with them. Many encourage you to stop making payments during negotiations, but this can get in the way of discussions.
Lowering your interest rate could have a huge impact on your ability to pay off debt, especially if you’re paying off high interest credit cards or loans. If you are early in the process and still have fair credit, you may be able to get a debt consolidation loan to reduce your interest and consolidate your debts into a single payment.
Consider the scenario below where the borrower has a high interest car loan and two credit card balances that have been slapped with high interest rates due to missed payments:
The above borrower makes $695 in minimum debt payments each month. A 72-month debt consolidation personal loan could reduce the total monthly cost by $239 and save over $4,909 in lifetime interest:
If our borrower continues to pay $695 a month, not $456, he could be debt free in just over three years and save about $11,000 in interest.
When consolidating debt, you may want to avoid secured loan options like a second mortgage or home equity line of credit (HELOC) because loans that use your home as collateral put your home at risk.
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Frequently Asked Questions (FAQ)
Can student loans be canceled by bankruptcy?
Some student loans can be canceled through the regular bankruptcy process, including: loans paid directly to the student that have exceeded the cost of attendance; loans granted to students attending school less than half the time; and loans for schools not eligible for federal Title IV student aid funding. But in most cases, you’ll also need to prove “undue hardship” – which can be difficult – and take legal action called “adversarial proceedings”. The US Department of Education is considering a policy change that would make it easier to forgive federal student loans in bankruptcy.
What is the difference between chapter 7 and chapter 13?
Chapter 7 bankruptcy is designed for consumers with little or no income, and you must prove you are eligible to file by passing the means test. Many types of debt are erased completely by Chapter 7. Chapter 13 bankruptcy is available to most filers with regular incomes and requires you to agree to a debt repayment plan that typically lasts three to five years. Once the repayment period is over, any remaining debt is often forgiven.
Can I declare bankruptcy if I have already done so?
If you have declared bankruptcy and your case has been rejected, you must wait 181 days before you can file again. If you have already filed for Chapter 7 bankruptcy, you cannot file again for eight years. If you filed for Chapter 13, you cannot file again for six years.