How You Know When It's Time For Bankruptcy

By Stacy Johnson. Last updated 7 February 2010. 4 comments

While producing news stories and researching books (here's my latest: Life or Debt 2010), I've explored virtually every way to deal with debt. This story is about the nuclear bomb of debt destruction: bankruptcy.

When I produced the news story you’re about to see, I was just looking for a lawyer to interview regarding the basic facts. What I got in addition was a heartbreaking, personal story from just one of the 1.4 million Americans who filed bankruptcy last year.

Watch this 90-second news story, then meet me on the other side and we’ll go into more detail about what bankruptcy is how it compares with other ways of dealing with a debt dilemma.

So bankruptcy is the ultimate debt destroyer, because rather than paying it back, you're often wiping it out, or at least partially so. But it’s not the only way out.

You could obviously try to repay your debts yourself. You can try to repay them in full on better terms by going to a credit counselor. You can try to satisfy specific debts by paying less than you owe. Or you can try to take out a new loan to pay off your old ones in a process known as debt consolidation.

When is bankruptcy the right choice? Ultimately, you file bankruptcy because there’s no other way out. For example, in Ron's case, his monthly payments were higher than his monthly retirement income. He couldn't repay the debt, even with help from a credit counselor, debt consolidation or settlement.

But before you even contemplate bankruptcy, understand it. For individuals (as opposed to corporations) there are two types:

  • Chapter 7, which wipes out all your debts
  • Chapter 13, where you’ll be required to pay some of your debts back over time

Which you’ll be eligible to file depends on how deeply in debt you are relative to your ability to pay, as well as other factors, including the median income where you live. But even a Chapter 7 won’t rid you of all your debts. You can’t ditch student loans (except in rare cases), IRS liens (unless you successfully file a tax bankruptcy), child support, or alimony. You can’t use Chapter 7 to discharge debts you incurred through fraud. And bankruptcy isn't a way to get rid of mortgage debt.

It will probably come as no surprise that bankruptcy will also cost you big time when it comes to your credit score. According to Fair Isaac (creator of the most popular credit scoring model), you’ll lose from 130 to 240 points out of a possible 850. That’s enough to turn even a perfect score into a subprime one. (Here's a story I did about three ways to improve your credit score.)

What type of credit card are you interested in?
How much do you spend per month?
Do you carry a balance?

Is there credit after bankruptcy? Yes, if you can afford it. There are people who will sell you a car on credit or give you a credit card, but expect to pay exceedingly high rates of interest, since you’ll be a high-risk borrower.

And bankruptcy will remain in your credit history for 10 years. Most other infractions only last seven. But a bankruptcy won’t leave you living in the streets. Depending on the state where you file, you might still end up with some home equity, a car, clothing and furnishings.

The cost of bankruptcy filing varies, but expect to pay at least $1,500. (Here are three tips to lower lawyer bills.)

Does all this sound like I’m discouraging you from filing bankruptcy? Not if you're like Ron.

Bankruptcy involves hiring a lawyer and going to court, which makes it by far the most serious way to deal with debt. It also means getting rid of most of your assets and really screwing up your credit history. That's why it's a measure of last resort. But most people don't mess up by filing. They mess up by not doing it soon enough.

Because my news story was so short, you didn’t get to hear much from Ron, the guy who filed bankruptcy. You didn't get to see the tears in his eyes when he described how he had sacrificed everything he had to take care of his grandchildren. Or the relief on his face as he talked about putting his pride aside and getting help.

For months before he walked into that lawyer’s office, he’d been verbally abused by creditors and frozen like a deer in the headlights by shame. He admitted feeling suicidal.

When you're in major trouble, whether it's legal, health, or financial, hesitation is natural. But recognize that when you hesitate, you waste stress, time, and money. Before he got help, Ron wasted all three trying to stay ahead of bills he had no hope of ultimately paying. Especially since rather than helping him, his lenders chose instead to bury him with impossibly high rates and penalty fees.

So if you ever consider this path, or know someone who does, remember that. Assess your situation honestly, forget your embarrassment, and talk to a lawyer or credit counselor sooner rather than later. They can give you advice on your options and, if bankruptcy is the right one, they can help with a strategy to maximize what you keep and minimize what you lose.

If you're a proud, responsible person like Ron, you'll probably feel that bankruptcy is the end of your life. But it might just turn out to be a new beginning.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.

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Guest's picture
Robert

Bankruptcy is a darn good deal for many of those who are in 30k of debt. Slap down $1500 and your debt is, more or less, wiped clean. You'll have a scarlet letter on your credit report for a few years, but if you own your home, who cares?

Guest's picture

Chapter 9 of Elizabeth Warren's personal finance book, "All Your Worth" includes detailed information on bankruptcy, such as the two main types of bankruptcy, the types of debt bankruptcy does (and does not) erase, what bankruptcy accomplishes, the process of filing bankruptcy, what NOT to do at bankruptcy court,and WHEN to file for bankruptcy.(Ms. Warren teaches bankruptcy law at Harvard Law School.)

Guest's picture
Jim

"...if you own your home, who cares?"

Most people in most states don't get to keep a home free and clear and wash away debts in bankruptcy. The details depends on what state you live in. Some states allow you to exempt an unlimited amount of home equity from bankruptcy. Other states offer ZERO protection of home equity. Over 30 states allow you to shelter some home equity of varying amounts less than $50,000 from exemption.

Guest's picture
Guest

If you are thinking about filing bankruptcy, please consult a lawyer. Not all of the information listed here is correct.