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What You Need to Know about Bankruptcy

Reading time: 4 Minutes

December 21st, 2020

photo of bankruptcy law books photo of bankruptcy law books

If you're thinking about filing for bankruptcy, it's probably because debt has piled up, and you now owe more money than you're able to repay. Bankruptcy can be a useful tool to help you find a way out of financial crisis.

Of course, it does have its limitations, and you should think carefully about whether the benefits of declaring bankruptcy outweigh the very real downsides. Here are some of the basics you need to know about the process.

What is Bankruptcy?

Bankruptcy is a legal proceeding handled in federal Bankruptcy Court that may allow you to be forgiven of debts you can't pay, while setting up a plan to pay other creditors at least some of what you owe.

A federal bankruptcy judge will make the decision on your case based on the facts presented, not only on your behalf, but by your creditors, who have the opportunity to object in court.

However, it doesn't matter if you got into debt due to bad luck or bad decisions. If your request for bankruptcy is approved, at the end of the process, after you've completed any payment plans and met all the terms of the bankruptcy agreement, your remaining debts will be discharged.

A bankruptcy will stay on your credit report for up to 10 years, making it a decision that should be carefully considered. In general, it may be worth pursuing bankruptcy if it would take longer than five years to pay off your total current debt.

Pros and Cons of Filing for Bankruptcy

The main reason to file for bankruptcy is that it legally erases your debts and gives you a fresh start. It can save your home from foreclosure, prevent or delay lenders from repossessing your car, and stop wage garnishment and other legal actions creditors take to pursue repayment.

On the downside, filing for bankruptcy will definitely damage your credit score for years to come. This can have a real impact on your ability to function financially. It can make it harder to get a loan, be approved for a mortgage or take out a credit card. Your bankruptcy will also be a matter of public record, so it might even affect your ability to rent an apartment or be hired for certain jobs. And, while bankruptcy can offer a chance to "wipe the slate clean" to an extent, there are some debts that can't be erased. These include federal student loans, alimony, child support, taxes and personal injury debts. In addition, if you rack up new debt after filing for bankruptcy, you'll still be responsible for paying that additional amount back.

Chapter 7 Bankruptcy

The most common path for individuals in financial crisis is Chapter 7 bankruptcy. The basic idea is that some portion of the assets you own will be sold off to pay your creditors. This is suited to people with lower incomes and fewer assets. It's also the only option for some individuals who don't qualify for Chapter 13 bankruptcy because their debts are too high.

With Chapter 7 bankruptcy, you'll have to give up most of your property, which will be sold off. The proceeds, along with any cash or investments you have, will be used to pay your creditors. You'll be allowed to keep some key assets, including your primary residence and the vehicle you use for work, as well as retirement savings, Social Security checks, welfare benefits, and veterans benefits. These are called “exempt property." But other assets, such as the money in your bank accounts, stock investments, a second home or second vehicle, art, collectibles, electronics and jewelry, could all be sold to pay your debts. At the end of the process, any remaining debts will be erased. A Chapter 7 bankruptcy will stay on your credit report for 10 years.

You may not qualify for Chapter 7 bankruptcy if your income is higher than your state's median household income, unless you can show you have no disposable income that could be used to pay down your debt.

Chapter 13 Bankruptcy

If your income is too high to qualify for Chapter 7 bankruptcy, or if you have a lot of property you don't want to be sold off, Chapter 13 bankruptcy might be a better option. Under Chapter 13 bankruptcy, you must come up with a debt repayment plan and follow it to pay off your creditors within a certain period of time, usually three to five years.

If you complete the plan, you can keep your property. If you don't complete the repayment plan, you may have to start over in Chapter 7 bankruptcy. A Chapter 13 bankruptcy will stay on your credit report for seven years.

Alternatives to Bankruptcy

Bankruptcy can be a useful option for some people, but because it comes with a range of negative consequences, you should definitely take a hard look at alternative solutions. Consider whether any of these options could work for you.

  • Talking with creditors to negotiate an extension, a lower interest rate or lower monthly payments.
  • A debt management plan, where you work with a debt management company to negotiate a deal with your creditors.
  • Debt consolidation, which involves transferring high-interest-rate balances to a low annual-percentage-rate credit card or personal loan, refinancing your mortgage or taking out a home equity line of credit.
  • Debt settlement, where you offer creditors a lump-sum in exchange for the rest of your debt being forgiven.

Making the decision to file for bankruptcy isn't easy, but if you can't pay your debts, it can sometimes be the best option. By understanding the process and choosing the path that's right for you, you can get a handle on your debt and start fresh financially.

Once you've made a decision on declaring bankruptcy, it may be time to start working on rebuilding your credit score. Check out our blog on repairing your credit with four simple steps.

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