Filing for bankruptcy is a legal proceeding when a person or business cannot pay their debts. It can be a chance to eliminate a great deal of financial stress, put an end to collection calls and letters, and provide an opportunity to remake your financial life. Even so, declaring bankruptcy is not something you should take lightly.
While bankruptcy can, in some cases, reduce or eliminate your debts, it can also have serious consequences, including long-term damage to your credit score. That, in turn, can hamper your ability to obtain new lines or credit, and even make it difficult to get a job or rent an apartment.
Key Points
• Bankruptcy is a legal proceeding when a person or business cannot pay its debts, with options tailored to different financial situations.
• Chapter 7 bankruptcy typically involves liquidating nonexempt assets to pay off debts, with remaining debts discharged.
• Chapter 13 bankruptcy generally requires a court-approved repayment plan over three to five years.
• Specific eligibility criteria must be met to file for either Chapter 7 or Chapter 13 bankruptcy.
• Both bankruptcy types aim to provide a fresh financial start, despite differing approaches, requirements and resulting decreases in credit scores.
Bankruptcy Defined
Bankruptcy is defined as a legal proceeding that is triggered when a person or a business is unable to repay its debts or obligations. This process can offer a hard reset for people who can’t pay their bills.
When the bankruptcy procedure gets underway, the debtor’s assets are assessed (and this can range from money in bank accounts to real estate and beyond) and may be used to pay back some of what the person or business owns.
What Are the Types of Bankruptcy?
For individuals, there are two main different kinds of bankruptcy:
• Chapter 7 Also known as “liquidation bankruptcy,” this is bankruptcy in its most basic form. With this type of bankruptcy, your nonexempt possessions, such as homes and cars, are sold to repay existing debts. After this, many (if not all) of your debts are canceled outright in a four- to six-month process.
• Chapter 13 Chapter 13 Also known as a “reorganization bankruptcy,” this is a court-approved plan in which you use your income to make payments on your debts over a three- to five-year period. Some of your debts may also be discharged.
The main difference between the two options is that Chapter 7 allows the debtor to eliminate all dischargeable unsecured debt, whereas Chapter 13 allows for payments to be made on those debts. Here are a few more points to consider:
• You may be prevented from filing for Chapter 7 bankruptcy if you earn enough income to repay your debts in a Chapter 13 bankruptcy plan. On the other hand, you may not qualify for Chapter 13 bankruptcy if your debts are too high or your income too low.
• If you have substantial equity in your home, you could potentially lose your home if you file for Chapter 7. If you file for Chapter 13, you can keep your home and pay off any mortgage arrears through your repayment plan.
• Chapter 13 bankruptcy stays on your credit report for seven years, while Chapter 7 bankruptcy stays on the report for 10 years.
• Some debts, like child support obligations, alimony, student loans, and some tax obligations, cannot be wiped out in either type of bankruptcy.
• Also keep in mind that bankruptcy won’t relieve you of your obligation to pay your mortgage, though it might make your mortgage payments easier to make by getting rid of other debts.
When To Consider Bankruptcy as a Solution
Life circumstances and financial situations can vary significantly from person to person, so there is no hard and fast rule for when to declare bankruptcy.
However, you may want to start by asking yourself the following questions:
• Are you unclear on exactly how much you currently owe?
• Are you only able to make minimum payments on your credit cards?
• Are you getting calls from debt collectors?
• Do your financial problems make you feel hopeless, out of control, or scared?
• Are you using your credit card to pay for necessities because you have so little cash in your checking account?
• Are you thinking about debt consolidation?
If you answered yes to two or more of these questions, you may want to at the very least give your financial situation more thought and attention.
You may also want to start doing some research (or, if possible, speak with a consumer law attorney) to see if your debt qualifies for bankruptcy, as well as how filing for bankruptcy would affect your life and financial situation.
Alternatives to Bankruptcy
While bankruptcy can sometimes be the best way to get out from under crushing financial burdens, it is not the only way. There are alternatives that can often reduce your debt obligations without some of the negative consequences of bankruptcy. Here are a few you may want to consider.
Credit Counseling
A counselor or counseling service specializing in helping people with debt problems might be able to come up with a solution that has not occurred to you, such as a modified payment plan or debt consolidation.
According to the Federal Trade Commission, you’ll want to look for a nonprofit credit counseling program, such as those offered by universities, military bases, credit unions, housing authorities, and branches of the U.S. Cooperative Extension Service. You can also find a nonprofit agency that offers bankruptcy counseling through the National Foundation for Credit Counseling .
Keep in mind that not all not all nonprofit organizations offer free services, so it’s a good idea to do your research before you sign up for any type of credit counseling services.
Negotiating with your Creditors
Creditors would often rather settle a debt with you than have it discharged in bankruptcy. Debt settlement is an agreement between you and your creditors that you will pay a lump sum, possibly far below what you owe, in order to settle the matter.
But it may not be quite as tidy as it sounds. The creditors take a loss, and likely so will your credit score. You’ll also still need to pay taxes on the forgiven amount, because it will be considered revenue (money you’re getting back).
There are debt settlement companies out there to help you negotiate with creditors, but not all are created equal — some of them charge steep fees and can’t guarantee they will get you the settlement that makes the most sense for you.
It’s a good idea to carefully vet any debt settlement company you are considering working with.
Recommended: Money Management Guide
Cutting Back on Expenses
You may want to give some deep thought to the way you live and currently spend your money. Your lifestyle and financial habits may be what inched you toward bankruptcy in the first place. A good way to start is to set up a personal budget, which involves looking at what’s coming in and what’s going out each month, and then looking for places to trim spending.
Even small steps, like making your own lunch, walking instead of burning gas by driving, keeping the heat or air conditioning use to a minimum, and brewing your own coffee could help you free up cash and transfer money to go toward paying your debt.
While it can be tough to live on a budget at first, with time, you may find yourself becoming more solvent and less burdened.
Debt Consolidation
With debt consolidation, you roll all your debts into one new loan account, preferably with a lower interest rate. This can enable you to pay off your debt and make one monthly payment going forward.
Having just one payment may make it easier to manage your existing debt, and could possibly save you on interest as well.
Refinancing or Modifying Your Mortgage
If your credit is still good enough, you may be able to refinance your mortgage to a new rate that could get your monthly payment low enough that it saves you from bankruptcy.
If you’re not able to refinance at a lower rate, you may be able to qualify for a mortgage modification. A mortgage loan modification is a change in your loan terms that could reduce your monthly payment.
If your lender allows it, it could involve extending the number of years you have to repay the loan, reducing your interest rate, and/or forbearing (or reducing) your principal balance.
You’ll want to keep in mind, however, that if you receive a loan modification and you still can’t make the payments, you could be at risk of losing your home.
Life After Bankruptcy
Bankruptcy can be the path forward from overwhelming debt. There are steps to take afterward to help get your finances back on track.
Focus on your credit. Your credit score will typically be negatively impacted and significantly so. You’ll need to be diligent about paying your bills on time and also taking steps to rebuild your score. A secured credit card, which involves you putting down a deposit that serves as collateral and your credit limit, could be a valuable move to make.
Consider cosigners. If you need to buy a car or are planning to buy a house in the near future, investigate having cosigners (perhaps a close relative) on your loans to help you gain approval. Or you might see if a trusted friend or relative would be willing to offer you a loan.
Seek financial counseling. Having a professionally prepared financial plan to move forward with after this difficult experience can be a source of insight, information, and support. Also, skilled guidance can help you steer clear of taking on too much debt in the future. In addition, you can learn some solid financial principles, such as automatic transfers to build an emergency fund to handle future challenges that require a quick infusion of cash.
The Takeaway
Bankruptcy is a legal proceeding that can help you get out from under crushing debt. The process involves either liquidating (or selling off) your assets to pay your debts or adhering to a court-ordered repayment plan. However, bankruptcy information stays on your credit report for seven to 10 years and can also make it difficult to get credit, buy a home, or sometimes get a job.
Before considering bankruptcy, you may want to first explore other debt management options.
Interested in opening an online bank account? When you sign up for a SoFi Checking and Savings account with direct deposit, you’ll get a competitive annual percentage yield (APY), pay zero account fees, and enjoy an array of rewards, such as access to the Allpoint Network of 55,000+ fee-free ATMs globally. Qualifying accounts can even access their paycheck up to two days early.
FAQ
What debts can be discharged through bankruptcy?
In general, credit card debt, medical bills, and personal loans are dischargeable in bankruptcy. However, not all debts can be discharged. For instance, you may still owe child support, alimony, some unpaid taxes, and other debts.
Will I lose all my assets if I file for bankruptcy?
It depends on your specific situation. Here are some of the assets that can be lost when you file for bankruptcy: real property (meaning land and buildings), personal property (such as jewelry, art, clothing), and intangible assets, such as retirement accounts and alimony.
How does filing for bankruptcy affect my credit score?
Filing for bankruptcy can significantly lower your credit score, and it can stay on your credit report for seven to 10 years. There isn’t a specific figure for how much it will drop, but there is a tendency for those with a higher starting score to see a bigger decrease than those whose score was lower from the beginning.
How does one file for bankruptcy?
Typically, you file for bankruptcy by consulting with a lawyer who specializes in this type of proceeding, gathering necessary documents, attending a credit counseling course, filling out the appropriate forms and submitting them with a filing fee, attending a meeting of creditors, and then determining whether a repayment plan is possible or learning about the discharge of debt.
Will I lose my car if I am bankrupt?
Whether you can keep your car after bankruptcy will depend on such factors as the type of bankruptcy, the value of the vehicle, and whether you can pay for it or not.
About the author
Julia Califano
Julia Califano is an award-winning journalist who covers banking, small business, personal loans, student loans, and other money issues for SoFi. She has over 20 years of experience writing about personal finance and lifestyle topics. Read full bio.
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