Understanding Bankruptcy

Pros & Cons of Filing for Bankruptcy

Filing for bankruptcy is a path some consumers consider when facing significant financial pressure. In fact, in the past 12 years, 12.8 million Americans turned to it as the solution to their financial strain.

While entering bankruptcy can alleviate the excessive financial burden, it isn’t the best course of action in every situation. A bankruptcy can wreak havoc on your finances, and its impact can extend for many years down the road.

Unfortunately, many consumers pursue bankruptcy without a full understanding of the implications or extensively exploring other options. The decision to file for bankruptcy should be considered carefully, weighing not only the benefits and the potential relief it can bring but also the drawbacks.

A common misconception

Some consumers incorrectly assume bankruptcy means one thing and one thing only — you automatically get to walk away from all your debts. That assumption could make for a rude awakening for those looking to file, according to Bruce McClary, a former credit counselor and vice president of communications for the National Foundation for Credit Counseling (NFCC).

“Some people think bankruptcy is one-size-fits-all and that if you file, all of your debt just magically goes away. It’s not that easy,” McClary said. “There’s a certain process you have to go through.”

There are six types of bankruptcy, but the average consumer will usually file either Chapter 7, in which assets are liquidated to settle debts, or Chapter 13, in which a repayment plan is worked out. Of the 12.8 million consumer bankruptcies in the past 12 years, 8.7 million, or 68 percent, filed Chapter 7.

Depending on which bankruptcy you qualify for, what kind of debt you have and the value of your assets, yes, it is possible to walk away from some of your debts. But there’s a lot more to the process than that, and each type of bankruptcy has its own pros and cons.

Filing bankruptcy: The pros

Here is a look at some of the benefits of filing for bankruptcy.

You are granted an automatic stay.

The instant you file, you are protected under a provision in bankruptcy law called automatic stay. Creditors cannot pursue payment of your debts or take other actions against you until the bankruptcy is discharged or a repayment plan has been finalized.

Relief from dealing with multiple creditors.

Filing bankruptcy can mitigate the pressure and overwhelming nature of handling numerous creditors. “There could be a very immediate relief once the banks discharge [your bankruptcy] in that you don’t have to repay some or all of your financial obligations,” McClary told LendingTree. “But it all depends on the type of bankruptcy you file.”

A court-appointed representative.

Once you file your petition for bankruptcy, you will be assigned a trustee who will see your case through to discharge. They will operate on your behalf throughout the process, including handling all communication between you and your creditors, and in the case of Chapter 13 bankruptcy, they will be the ones to receive and process your payments.

Prevention of further legal action.

“The biggest benefit,” said McClary, “is that you could get cleared of debt that you owe and you’re having difficulty paying. And it could potentially head off any future legal trouble that you have related to the non-payment of that debt.” However, he cautions that if there is already a case in court at the time you file bankruptcy, based on the timing, you may not be cleared of it.

You may be able to keep some assets.

In Chapter 13, you are likely holding on to your assets as you repay them, but even in Chapter 7 in which your assets are liquidated, some may be protected.

Back taxes can be addressed.

John Colwell, president of the National Association of Consumer Bankruptcy Attorneys, says that filing bankruptcy can be an effective way to deal with back taxes, especially in a situation where wages are being garnished. “It can force the IRS or state to receive payments in an organized fashion,” he told LendingTree.

In some cases, the tax debt can be dismissed altogether. “There are some very specific rules that have to be followed,” Colwell said, “but you can get rid of older taxes.” He went on to say that it is usually not the case with newer taxes.

Can prevent foreclosure or car repossession.

Colwell says a Chapter 13 bankruptcy can be a tool to delay or stop a foreclosure or car repossession.

Debts will be settled for less than what you owe.

Your creditors will be forced to accept whatever payment is determined in your bankruptcy case. This includes receiving no payment at all. “If you qualify for a Chapter 7 you could have all of your unsecured debts liquidated — your credit card debt, your small loan balances, [etc.]. You wouldn’t have to pay any of that back,” McClary stated.

“However, if you file Chapter 13, that gets a little bit trickier because you may have to pay some of that back depending on the decision of the bankruptcy trustee and the creditors that you owe,” he said. “It’s all based on your current financial situation and the capacity that you have to repay.”

Some debts will be completely written off.

Once the bankruptcy is discharged, any debts that are written off are gone for good.

Decisions are final.

If creditors approve a deal, they cannot reverse it and ask for you to pay more than what was agreed upon.

A fresh start.

Bankruptcy can potentially provide you with a much needed clean slate to rebuild your financial life and healthily reestablish your credit.

The potential for your credit score to increase.

It’s no secret that bankruptcy can demolish your credit, but depending on your score before entering bankruptcy — which, chances are, wasn’t great — you could potentially see an increase as you start working with your creditors, in the case of Chapter 13. This is due in part to the fact that debt elimination lowers your debt-to-income ratio, one of the factors that determine your credit score.

You can take on new credit while you are repaying existing debts.

Colwell says the wait and the method of rebuilding credit after bankruptcy has changed over the years. “I’ve got clients who are getting credit cards almost immediately after they get their discharge order, if not sooner,” he said. However, there are certain limitations you will face as you attempt to take on new credit.

Filing bankruptcy: The cons

Of course, filing bankruptcy also comes with many drawbacks.

You could lose assets of value.

Depending on which type of bankruptcy you qualify for, your income, the equity in your assets and other factors, you may lose your home, car and other items of value.

The cost.

You will need to cover the costs of bankruptcy including service and court fees. The average Chapter 7 bankruptcy case costs between $1,309 to $1,414 in out-of-pocket costs, while the average Chapter 13 bankruptcy costs $1,809, according to the American Bankruptcy Institute. (In some cases, you could qualify for legal aid if you cannot cover the fees.)

Federal student loans are exempt from bankruptcy.

In most cases, your federal student loans will not be dischargeable; while there are some exceptions, they are rare. According to McClary, “you should expect that your federal student loan debt is not going to be dischargeable through bankruptcy.”

However, Colwell, who has been a bankruptcy attorney for over three decades, said they can still be addressed. “Even though you can’t get rid of [federal] student loans, we can at least control them. If [the government] is dipping into someone’s Social Security money or is garnishing wages for an enormous amount, we can rewrite how much they get paid. We can control them for a three to five year period.” 

You may still be responsible for some debts.

Besides federal student loans, certain other liabilities cannot be written off — this includes some taxes, fines, child support, court orders and debts incurred through fraud. However, as with student loans, Colwell stated that how these debts will be collected going forward can be addressed.

If you have joint accounts, the other party is still responsible.

Creditors can demand payment from the non-bankrupt debtor or any cosigners you have.

Potential criminal charges.

The information you provide when filing for bankruptcy will be scrutinized. If you provide inconsistent or false information, you could face legal action.

Long process.

A Chapter 7 bankruptcy moves pretty quickly and typically discharges within a few months; a Chapter 13 bankruptcy, however, is a much longer process. As Colwell told LendingTree, “You’re in an open bankruptcy for three to five years, and that’s a bad thing for purposes of … making financial moves.”

You could lose your business.

If you own a business and the trustee in your case determines it has value, you could be forced to sell it. In some instances, the trustee may operate the business until its sale.

Possible eviction.

If you rent your home and are behind on your payments, you could be forced to leave the property once the bankruptcy is discharged.

Trouble renting in the future.

You could experience difficulty renting a home after declaring bankruptcy, as some landlords or management companies may automatically dismiss prospective tenants who have a bankruptcy in their past.

Impact on your job or career.

Depending on your field or job, your bankruptcy could disqualify you from holding certain positions. For example: “If you work for an employer such as the federal government or a contractor to the federal government where it requires a security clearance,”  said McClary, “a bankruptcy or delinquency on credit accounts could flag you as a security risk that could then put your job in jeopardy.”

Additionally, you would be ineligible to hold certain public office positions, to serve as the trustee of a charity or pension fund or to even volunteer for a role in which you would be handling finances. A bankruptcy would also make you unable to be a company director or trade under a name other than your own.

Your bankruptcy will be made public.

Bankruptcies are publicly reported, so there is potential for people you know to discover that you filed.

Your trustee may continue to administer your assets after discharge.

Depending on the specifics of your case, the trustee may pursue the sale and distribution of your assets after your debts have been discharged. This can include assets and income, such as an inheritance or divorce settlement, acquired within 180 days of the discharge.

Drop in your credit score.

Depending on your credit score before filing, you could see a significant drop.

Difficulty gaining future credit.

Your bankruptcy will follow you for some time. Anytime you apply for credit of $500 or more you will need to report your bankruptcy.

High-interest rates and low limits when applying for new credit.

Even though you may qualify for new credit after filing bankruptcy, it may come at a premium. “The fact that bankruptcy is reporting on your credit file will most likely lead to the highest interest rates and fees and possibly lower credit limits,” McClary warns. “Rebuilding your credit could be a costly process.”

The waiting period to purchase a home.

You’ll need to wait before you qualify for a mortgage, anywhere from one to four years, depending on the type of mortgage.

Increase car insurance premiums.

Car insurance companies use an industry-specific credit report based on your credit file, so if you need to secure auto insurance after filing bankruptcy, your rates will likely be impacted.

It stays on your credit report for up to 10 years.

Your bankruptcy will remain on your credit report for up to 10 years from the date of discharge. While the impact it will lessen over time, it will undoubtedly be a factor in any financial or career move that requires checking your credit.

“It’s not all roses after you file bankruptcy,” McClary told LendingTree. “There are some limitations that you’re going to have to face.”

It doesn’t address the cause of your financial trouble.

While bankruptcy can be a solution in certain circumstances, it doesn’t fix what led to the problem. You could repeat your mistakes and end up looking to file a second time.

“I’ve seen that happen first-hand,” said McClary. “It is possible that people [file] bankruptcy, thinking it’s going to resolve all their problems and then find themselves dealing with the same financial mess. But with restrictions on repeat filing, they’re in a much worse situation because now they can’t file again so quickly.”

He cautions: “You really are setting yourself up for a very difficult time unless you address the circumstances that led to your decision to file bankruptcy and the root cause of your problems.”

It cannot be undone.

Bankruptcy is final. You cannot change your mind once your case is finalized.

Consider all your options

Because of the severe implications, bankruptcy should be seen as a last resort, according to McClary — “in situations where you’ve explored all your other options and you’re left with the decision to file bankruptcy,”  he said, “you could benefit from either total or partial liquidation of the debts that you owe.”

It’s important to think past the immediate relief bankruptcy can provide and to consider the full impact of filing. McClary stresses the importance of pursuing an objective opinion on whether or not bankruptcy is the best option for you. He suggests seeking professional help before entering the process.

“I would advise people to meet with a nonprofit credit counseling agency or other financial professional and talk to them about your financial situation in greater detail before you decide to talk to a bankruptcy attorney,” McClary said. “It would really help you to get a better understanding of the problems, the nature of the problem, and what the cause and the solutions might be. Then you can make a more informed choice about whether or not to file.”

“Once that bankruptcy is discharged, there is no turning back,” McClary warns. “You cannot undo that decision. And it stays with you for a long time. So it’s very important that you make as thoughtful and informed decision as possible before going down that road.”