Bankruptcy: A Last-Resort Option

For most people, filing bankruptcy is a last-resort option, deployed when all other debt and finance management alternatives have not worked. Filing a bankruptcy is viewed as the beginning of a “fresh start” and it does, indeed, free you from paying all or part of your debt owed. However, it’s important to understand that your negative credit history is not erased from the credit report when bankruptcy is filed. Accounts will be updated in your credit report to show “included in bankruptcy,” and they will remain on your credit history for seven years (Chapter 13) or reported for 10 years (Chapter 7, 11 and 10).

The decision to file bankruptcy should be considered carefully, as it will be captured on your credit report and will negatively impact your credit rating, potentially making it more difficult to get credit, insurance, employment, etc. It will also potentially increase the cost of credit or insurance. According to FICO research findings, the posting of bankruptcy information on a credit report can drop your credit score by 150 points or more.

In addition to negative impacts on your credit, there are also costs to think about if you are considering bankruptcy, as there are court filing fees and lawyer fees that can add up to several thousand dollars.

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It’s also important to understand that there are several different kinds of bankruptcies, with Chapter 13 and Chapter 7 being the primary types of personal bankruptcy:

Chapter 13 allows people with a steady income to keep property, like a mortgaged house or a car, that they might otherwise lose through the bankruptcy process. In Chapter 13, a repayment plan is approved by the court that allows one to use future income to pay off debts during a three-to-five-year period, rather than surrender any property. One is discharged of their debt after all payments have been completed under the plan.

Chapter 7 is known as straight bankruptcy, and involves liquidation of all assets that are not exempt. Exempt property may include automobiles, work-related tools, and basic household furnishings. Some of your property may be sold by a court-appointed official—a trustee—or turned over to your creditors. You must wait eight years after receiving a discharge in Chapter 7 before you can file again under that chapter. The Chapter 13 waiting period is much shorter, with as few as two years between filings.

According to the FTC, both types of bankruptcy may get rid of unsecured debts and stop foreclosures, repossessions, garnishments, utility shut-offs and debt collection activities. Note that personal bankruptcy usually does not erase child support, alimony, fines, taxes, and some student loan obligations. And, unless you have an acceptable plan to catch up on your debt under Chapter 13, bankruptcy usually does not allow you to keep property when your creditor has an unpaid mortgage or security lien on it.

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Bankruptcy reform rules passed in the 2000s also require that you must get credit counseling from a government-approved organization within six months before you file for any bankruptcy relief. Also, before you file for Chapter 7 bankruptcy, you must satisfy a “means test.” This test requires you to confirm that your income does not exceed a certain amount (the amount varies by state).

As you can see, the bankruptcy process is fairly complicated and there are also state-level considerations you must take into account. If you’ve reached a point where you are considering bankruptcy, I recommend that you take the time to research your options and, if possible, seek legal assistance to help you make the most informed decision.

Also, regardless of what others may tell you, you should be fully aware that a bankruptcy will likely have a negative impact on your credit rating for a period of time.

Image: Michael Pereckas, via Flickr.com