The Pros and Cons of Filing for Bankruptcy

When you’re struggling with overwhelming debt or you’re in danger of a foreclosure or repossession, bankruptcy is one option that could provide you with financial relief. Yet despite the benefits that bankruptcy may provide in times of financial hardship, there are also drawbacks to this form of protection. It’s important to understand the negative consequences of bankruptcy and how long it might take you to overcome them.

If you’re considering bankruptcy, you should also have a clear understanding of how the process works—including the two primary types of bankruptcy. Furthermore, you may also want to consider bankruptcy alternatives to see if another option might be a better fit for your financial situation.

How does bankruptcy work?

Bankruptcy is a legal process that can offer you protection and relief when you can’t afford to repay your debts as promised. In some situations, bankruptcy might eliminate all of your debt. At other times, bankruptcy may help you restructure debt and stretch out your monthly payments under the supervision of a bankruptcy court trustee. It all depends on the type of bankruptcy you file. (More on the different types of bankruptcy below.) ^[1]

When you first file for bankruptcy, creditors have a legal obligation to stop their debt collection attempts. As a result, procedures like repossessions, foreclosures, and wage garnishments must cease—at least on a temporary basis. This process is called an automatic stay. ^[2]

Yet it’s important to note that bankruptcy won’t resolve every type of debt, including the following.

• Most tax debts
• Most student loan debts
• Child support
• Alimony
• Debts you forget to list in your bankruptcy ^[3]

You should also understand that bankruptcy won’t wipe out a lien on a secured debt. For example, filing for bankruptcy protection might pause foreclosure proceedings. But if you remain past due on your mortgage payment, the lender could petition the court to lift the automatic stay. If the bankruptcy court grants the lender relief from the automatic stay (which it often does), the lender would be free to foreclose on your home even in the middle of a bankruptcy filing. ^[4]

Therefore, if you have property you want to keep (like a house or a vehicle) it’s important to talk to an attorney about the different types of bankruptcy options. Certain types of bankruptcy might help you protect your assets. Other solutions may help you wipe out all of your debt.

Below are the two most common types of bankruptcy for individuals and how they work.

Chapter 7 bankruptcy

Chapter 7 bankruptcy, known as liquidation bankruptcy, is available to many low-income filers as well as some higher earners with significant monthly expenses (e.g., large families and certain types of high debt obligations). With this option, a court-appointed trustee may sell off or turn over some of your assets to creditors to pay off a portion of your debts. From there, the court will discharge the remainder of your debts that you’re eligible to include in your bankruptcy filing. ^[5]

On a positive note, you may be able to keep certain assets during a Chapter 7 bankruptcy. The list of assets that are exempt from bankruptcy varies from state to state. Yet you may be able to hold onto the primary vehicle you drive to work, home furnishings, retirement accounts, and perhaps even your home. ^[6]

When you file for Chapter 7 bankruptcy, the process takes around four to six months from start to finish. Once the court discharges your debt, you no longer owe your creditors any money. But the record of the bankruptcy will remain on your credit report for up to 10 years from the date you file. Furthermore, as long as the record of your bankruptcy is on your credit report, it has the potential to impact your credit score. ^[7]

It’s also important to understand that you can only receive a Chapter 7 bankruptcy discharge once every eight years. So, although there’s no limit to the number of times you can file for bankruptcy, there is a waiting period that limits how often you can qualify for this type of debt forgiveness. ^[8]

Chapter 13 bankruptcy

Chapter 13 bankruptcy is also known as reorganization bankruptcy. Rather than wiping out your debt and liquidating most of your assets, this option allows you to keep your property and reorganizes debt under a court-approved payment plan. Depending on your financial situation, a Chapter 13 bankruptcy will typically have you repay either a portion or all of your debt under a new “wage earner’s plan” over three to five years.

To qualify for a Chapter 13 bankruptcy, you must owe no more than $1,395,875 in secured debt and $465,275 in unsecured debt. Additionally, you’ll have to submit to a means test that will set your monthly payment amount and the length of your repayment plan. ^{[9] [10]}

Benefits of filing for bankruptcy

Filing bankruptcy isn’t a decision to take lightly. At the same time, there’s no question that bankruptcy has the ability to provide much-needed relief to people who are facing financial distress.

Below are some of the biggest benefits of filing for bankruptcy.

1. Automatic stay protection

When you file Chapter 7 or Chapter 13 bankruptcy, the court will grant you a form of immediate relief known as an automatic stay. An automatic stay means that until your bankruptcy case concludes, most creditors cannot start or continue collection efforts against you including the following.

• Eviction
• Wage garnishments
• Foreclosure
• Repossession
• Utility disconnection

If a lender or collection agency violates an automatic stay, you may be able to sue them. But creditors and debt collectors can also appeal to the court to lift the stay if the assets in question are likely to lose value by the time the proceedings are complete. ^[11]

2. Asset protection

Depending on the type of bankruptcy you file, you may be able to hold onto some of your assets while still receiving relief from debt. When you file a Chapter 13 bankruptcy, it’s common to keep your property as you repay some or all of your debts on time. And with Chapter 7 bankruptcy you may be able to hold on to essential assets like your primary vehicle, retirement accounts, and sometimes even your home depending on the laws of your state. ^{[12] [6]}

3. Court-appointed representative

When you’re overwhelmed with debt, attempting to communicate with your creditors on your own could cause significant financial stress. But when you file for bankruptcy, the court will typically appoint a trustee to work on your behalf.

In a Chapter 7 bankruptcy, a trustee manages the process of selling or distributing non-exempt assets for the benefit of your creditors. With Chapter 13 bankruptcy, a trustee will collect your payments, monitor case activity, and report to the court about how well you’re meeting your bankruptcy obligations. This type of relief—merely not having to deal with creditors alone—can be a welcome change when you’re worn out from a long financial struggle. ^[13]

4. Potential to pay less than you owe

If you qualify to file Chapter 7 bankruptcy, many of your unsecured debts may be dischargeable. As a result, you may not have to worry about paying debts such as credit card balances, medical bills, past-due utility bills, business debts, attorney’s fees, collection accounts, repossession deficiency balances, and more. ^[14]

With a Chapter 13 bankruptcy, you’ll repay debts over three to five years. But the court bases your payments according to your income and the types of debt you owe. Some Chapter 13 filers may be eligible for significant amounts of debt forgiveness. However, every case is different. You should consult with a trustworthy attorney to determine how this type of bankruptcy might work for your specific situation. ^[15]

Downsides of filing for bankruptcy

Of course, you shouldn’t file bankruptcy without also considering the drawbacks of doing so. Although bankruptcy has the potential to provide you with financial relief, it can also trigger long-term negative consequences with the potential to haunt you for years.

1. Bad credit

Filing bankruptcy can have a negative impact on your credit reports and credit scores. Although every situation is different, a bankruptcy might cost you as much as 200 points where your credit score is concerned according to Experian. ^[16]

It’s also worth noting that a bankruptcy can hurt your credit in multiple ways. Here’s how.

• The bankruptcy record: When you file bankruptcy, a record of the bankruptcy filing will typically show up on your credit reports with Equifax, TransUnion, and Experian. For a Chapter 7 bankruptcy, that record can remain on your credit report for up to seven years. A Chapter 13 bankruptcy can remain on your credit report for up to 10 years. As long as the derogatory mark stays on your credit report, it can damage your credit score. ^[17]
• The accounts: When you include a credit obligation in your bankruptcy filing, your creditor cannot continue collection activities. Instead, the creditor will inform the credit bureaus that the account is “included in bankruptcy.” Unfortunately, the fact that an account is in bankruptcy can have a negative affect on your credit score. And the more accounts you include in your bankruptcy filing, the more of credit score impact you might experience. ^[18]

2. Cannot discharge all debts

Unfortunately, bankruptcy isn’t able to relieve you of every type of debt. As mentioned, bankruptcy won’t wipe out child support or alimony obligations. Aside from limited circumstances, you can’t expect bankruptcy to discharge student loans or most tax debts either. Furthermore, many fines and penalties like traffic tickets and criminal restitution like DUI fines aren’t eligible to include in bankruptcy filings. And if you forget to list a debt in your bankruptcy, you’re out of luck as well. ^[3]

3. Bankruptcy fees

Despite the fact that many people seek bankruptcy due to financial hardship, filing bankruptcy isn’t free. Even though you’re pursuing bankruptcy to get out of debt, you must pay court fees to file. And if you hire an attorney to help manage your case, you’ll pay for his or her expertise as well.

The average court filing fee for a Chapter 7 bankruptcy is close to $340. For a Chapter 13 bankruptcy, the average filing fee is around $310. Meanwhile, attorney fees could range between $1,500 to $5,000 depending on how complicated your case is and your location. ^[19]

You must also receive credit counseling from an approved provider within six months before you file for Chapter 7 or Chapter 13 bankruptcy. Most credit counseling agencies charge $15 to $30 for this course. But credit counseling agencies must provide certain services without regard to your ability to pay. So, if you can’t afford to pay for your credit counseling class, you can remind the agency about this requirement. ^[20]

Finally, if you file a Chapter 13 bankruptcy you’ll have to pay commission to your court-appointed trustee. Trustee commission is a maximum of 10% of each monthly payment amount. ^[21]

4. Future financing challenges

With a bankruptcy on your credit report, it can sometimes be difficult to qualify for certain types of loans and credit cards in the future. When you find lenders that are willing to approve you for financing despite a previous bankruptcy filing, you’re likely to receive offers that feature higher interest rates and less attractive borrowing terms.

On a positive note, it’s possible to build credit again after bankruptcy. If you work to establish positive credit again after bankruptcy such as credit builder loans and secured credit cards, you may be able to put yourself in a better position for the future. Yet it’s critical to manage any new accounts you open in a responsible manner. On-time payments are a must. And if you open any credit cards, it’s also wise to maintain a low credit utilization ratio on those accounts as well.

Alternatives to bankruptcy

Despite the relief that bankruptcy can offer when you’re facing financial hardship, there are many long-term negative consequences as well. As a result, it’s wise to review alternatives to bankruptcy and whether any of these solutions might work for you. Below are three options to consider.

Debt consolidation

If you have good credit (or even fair credit) and you’re not past due on payments yet, consider whether debt consolidation might be a better option than filing bankruptcy. Debt consolidation is the process of using a new form of financing to pay off existing debt—typically at a lower interest rate than you’re paying now.

Debt consolidation comes in a variety of forms, including:

• Balance transfer credit cards
• Personal loans
• Home equity lines of credit
• Home equity loans
• Cash out refinance loans

It’s important to understand that all forms of debt consolidation involve risk. For example, if you take out a loan and don’t repay the lender as promised, you risk credit score damage and other negative consequences. But home equity financing and cash out refinance loans can be especially risky due to the fact that you’re pledging your home as collateral in exchange for the money you borrow. If you default on these loans, the lender has the right to foreclose on your home to recuperate its losses.

Credit counseling

Credit counseling from a reputable nonprofit organization is another alternative to bankruptcy that might work well for certain individuals. Credit counseling organizations typically offer a range of services including budgeting assistance, financial coaching, and debt management plans (DMPs)—often for a fee. A DMP is when a credit counselor negotiates eligible unsecured debt on your behalf to create new payment plans and potentially lower interest rates on certain accounts (like credit cards) to help you pay off debt. ^[22]

If you’re interested in finding out more about credit counseling and whether this solution could help you, consider beginning your research with the National Foundation for Credit Counseling (NFCC) or the Financing Counseling Association of America (FCAA). Both trade associations provide tools to help you find accredited nonprofit credit counseling organizations in your area.

Debt settlement

Debt settlement companies, sometimes called debt relief organizations, are for-profit companies you can hire to attempt to negotiate with creditors on your behalf. But debt settlement can be an expensive process, and it’s often unsuccessful.

In most cases, debt settlement companies will advise you to stop paying your creditors. As a result, you’ll incur late fees, penalties, and damage your credit reports and score. A debt settlement company may direct you to start paying money to a dedicated bank account to begin building a negotiation fund instead—an account for which you’ll likely have to pay monthly management fees. ^[23]

Once a debt settlement company begins to negotiate on your behalf, these companies often charge fees as high as 25% of any debts they settle. So, if a company settles a $2,000 credit card debt for $1,000, you’ll still owe the debt settlement company $500 in fees. That would cut your savings to only $500. Yet if you look back at how much your credit card bill was before late fees and penalty interest began to accrue, you might not really walk away with any savings at all in the long run. ^[24]

To make matters worse, your creditors could decline to work with a debt settlement company you hire all together. If that happens, you might endure months worth of credit score damage, late payments, late fees, and penalty interest with nothing to show for it.

Bottom line

If you’re facing a severe financial hardship, it might be time to talk to a trustworthy bankruptcy attorney and talk about your options. Yet before you make a final decision, consider all of the pros and cons and acknowledge how bankruptcy may affect you over the long term. It’s also wise to look at alternatives to bankruptcy and whether any of them might work for you.

Keep in mind that if you decide to file for bankruptcy, it doesn’t mean that your credit is doomed forever. Although bankruptcy stays on your credit for seven to ten years, you can take steps to start building your credit again and put yourself on a better path moving forward.

Sources

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About the author

Michelle Lambright Black is a nationally recognized credit expert with two decades of experience. She is the founder of CreditWriter.com, an online credit education resource and community that helps busy moms learn how to build good credit and a strong financial plan that they can leverage to their advantage. Michelle's work has been published thousands of times by FICO, Experian, Forbes, Bankrate, MarketWatch, Parents, U.S. News & World Report, and many other outlets. You can connect with Michelle on Twitter (@MichelleLBlack) and Instagram (@CreditWriter).

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