The very word “bankruptcy” is intimidating. Just the mention of the word conjures up visions of living on the street and being penniless, and even of not having a future. That’s more than a bit of an exaggeration of course. But there are serious consequences involved in bankruptcy filing that you should take very seriously before going down this road.
Still, if your debt and credit situation has passed the point of no return, bankruptcy may be the best option for dealing with it. And in many cases, it can be far better than the alternatives of debt negotiation and/or settlement.
What Is Bankruptcy?
Bankruptcy is a legal action that can be brought by either the debtor or the debtor’s creditors. It represents an opportunity for a debtor who can no longer afford to pay his or her debts to get legal relief that is granted by the courts.
As far as personal bankruptcy, there are two main types:
Chapter 13. This is an installment plan, in which you try to maintain a payment schedule that will ultimately pay some or all of your debt owed. In the process, creditors are prohibited from seeking collection action against you. Under this plan, you will generally be able to keep most or all of your assets.
The term of a Chapter 13 bankruptcy can be between three years and five years. The term is determined by income level. Generally speaking, the term will run not more than three years if you are below your state’s median income level, and up to five years if you exceed the median.
Chapter 7. This is a total bankruptcy plan. If you go this route all of your debts are discharged, except for student loans and certain tax debts. But there is an ugly side to this too. People in Chapter 7 can lose their personal assets since the bankruptcy trustee will liquidate those assets in order to settle their debts.
Certain assets are partially or totally protected under the plan. This can include a certain amount of real estate equity in your primary residence, the value of your car up to a certain level, and certain personal effects and household goods. Generally speaking, retirement assets are excluded from bankruptcy liquidation as well.
When Should You File For Bankruptcy?
There are serious consequences involved in filing for bankruptcy, particularly in regard to your credit. For this reason, if you are considering filing for bankruptcy, you should do so only under extreme circumstances.
Here are some examples:
You Can No Longer Meet Your Monthly Debt Payments. If you can’t pay your creditors, you may have no choice other than to seek bankruptcy relief from the courts. Even under a Chapter 13 filing, where you have to make monthly payments for several years, this arrangement can give you valuable time to rearrange and improve your finances so that you’ll come out of the process in a stronger financial position.
You Have No Assets to Liquidate to Pay Your Debts. If you are struggling to pay your debts, and there are no assets available to liquidate to pay down or pay off loans, bankruptcy will need to be considered as an option. Bankruptcy is considered to be a recommendation in many cases where your liabilities exceed your assets.
Your Income Has Collapsed. The sudden loss of a job or the collapse of a personal business could result in a near total loss of income. In that situation, not only will you be without the income to service your debts, but you will also struggle just to survive. Bankruptcy may be a completely necessary alternative in such a situation.
Your Credit Is Already Damaged. If you are facing any of the above circumstances, and your credit is already deteriorating, bankruptcy may be a necessary step. Credit problems tend to be a Catch-22 situation. As your credit scores decline, your ability to get new credit, or to refinance existing debt under more favorable terms, vanishes. You may even be subject to increased interest rates on existing debt as a result of declining credit scores.
In general, bankruptcy should be held as a last resort for dealing with credit and debt problems, and only after exhausting all other possibilities.
How Bankruptcy Affects Your Credit Score
Bankruptcy will have a major negative effect on your credit scores for an extended period of time. Even if you have perfect credit before filing, it is possible – even likely – that your credit scores will fall by well over 100 points. You can go from an excellent credit score of 750, down to the 600 level, which would leave you with a poor credit rating. That in turn can make it very difficult to rebuild your financial life.
Your bankruptcy filing will remain on your credit report for up to seven years if you file a Chapter 13, and up to 10 years for a Chapter 7 filing.
As I said, this will hurt your ability to borrow after the bankruptcy, and you may find that you’re unable to get credit of any sort for a year or two after filing. Even then, you may find that secured credit lines, or high interest/low credit limit accounts are all that you qualify for. This can make it very difficult to rebuild your life after the fact. After all, if it was a lack of money that caused your credit problems prior to bankruptcy, that situation will not improve as a result.
Apart from credit considerations, low credit scores can make it difficult to get certain new jobs or buy a new car, and next to impossible to rent a house or apartment. It might be entirely necessary to secure a living arrangement prior to filing for bankruptcy, particularly if your home will be included in the bankruptcy filing.
Once your bankruptcy has been discharged, rebuilding your credit will be mission-critical. You’ll most likely need some help working through that process, as it is one of the more difficult credit situations to overcome.
Have you ever filed for bankruptcy, or considered doing so? Can you think of a better way to deal with debt and credit problems?