Pros and Cons of Filing Bankruptcy
Bankruptcy is a legal process that might get some or all of your debts discharged (or forgiven). One in 10 Americans will file for bankruptcy at some point during their lifetime. Bankruptcy isn’t anyone’s goal, but it’s not something to feel ashamed about, either.
While bankruptcy can be a life raft if you’re drowning in debt, it’ll affect your credit history for seven to 10 years. Learn the pros and cons of filing for bankruptcy before deciding if this path is right for you.
- The two most common types of bankruptcy are Chapter 7 and Chapter 13.
- Filing for bankruptcy can provide you with a fresh start. It can also stop most collection efforts and lawsuits.
- If you file for bankruptcy, not only can it severely decrease your credit score, it can remain on your credit report for seven or 10 years, making future borrowing more challenging. You also risk losing your assets, such as your vehicle or home, if you file.
Chapter 7 vs. Chapter 13: Quick-reference comparison
In the U.S., individuals filing for bankruptcy have two options: Chapter 7 bankruptcy and Chapter 13 bankruptcy.
- Chapter 7, also known as “liquidation” bankruptcy, can discharge eligible debts entirely, but requires the filer to forfeit nonexempt assets and property, such as jewelry or a second car.
- Chapter 13 bankruptcy is referred to as a “wage-earner’s plan.” When you file for Chapter 13, you won’t have to forfeit any property, but you’ll need to set up a repayment plan to pay back creditors via a court trustee over a period of three to five years.
| Chapter 7 | Chapter 13 | |
|---|---|---|
| Best for | People with very low income and limited assets | People who have sufficient income to repay over time or who have nonexempt assets to protect |
| Eligibility requirements | Pass the “means test,” which compares your income to state medians and your debt total | Have unsecured debts of less than $526,700 and secured debts of less than $1,580,125, as of publication |
| Debts discharged? | Yes, within months | Yes, but only those eligible debts that remain after successfully completing a repayment plan of up to five years |
| Asset risk | Must forfeit nonexempt assets | Can keep your assets, provided you stick to your court-approved debt repayment plan |
| Typical timeline | Four to six months from initial filing to discharge | Three to five years from initial filing to completion of repayment plan and final settlement |
| Duration on credit report | 10 years | Seven years |
Bankruptcy isn’t for everyone. Before filing, be sure to consider other debt relief options that may be less impactful to your credit and finances.
The pros of filing for bankruptcy
If you’re overwhelmed with debt and have no way out, bankruptcy can give you a fresh start. Here’s how bankruptcy could be beneficial:
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It will stop most debt lawsuits, collections calls and wage garnishments
When you file for bankruptcy, you’ll get an automatic stay. An automatic stay will stop most lawsuits if you’re being sued by debt collectors. Debt collectors must also stop calling, and most wage garnishments will end.
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You will get help from a court-appointed representative
Even if you file for bankruptcy without a lawyer, you won’t handle everything yourself. Instead, the court will assign you a trustee.
The trustee will handle all communication from your creditors, relieving some stress for you.
The trustee will also sell your eligible assets on your behalf (or file no-asset paperwork with the court) if you file Chapter 7. Under Chapter 13, the trustee will collect your payments and send them to your creditors.
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You may no longer be legally responsible for your debt
You are not liable for discharged debt, and debtors must stop hassling you about it in the future. This only applies to eligible debt. Certain debts, such as back child support, cannot be discharged.
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You may no longer be legally responsible for your debt
Chapter 13 consolidates your debt. Instead of owing money to several lenders, you’ll have one bill to pay — your bankruptcy repayment installment. Bankruptcy repayment installments are typically due biweekly or monthly.
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It can help eliminate the hassle of dealing with multiple creditors
Chapter 13 consolidates your debt. Instead of owing money to several lenders, you’ll have one bill to pay — your debt repayment installment. These installments are typically due biweekly or monthly.
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You might not need to sell assets
With Chapter 13, you won’t sell your assets to repay your debt. Instead, you’ll pay your debt over time under a payment plan.
Chapter 7 requires you to sell assets — but not all assets are included. Everyday items like your clothes and car (depending on its value) are exempt from bankruptcy liquidation. Most Chapter 7 bankruptcies are no-asset cases, where the filer has nothing eligible to sell.
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It wipes out eligible back taxes
Filing for bankruptcy can help you address those back taxes you’ve been worried about. Tax debts that are older than three years can be discharged after Chapter 7 and Chapter 13 bankruptcy.
You must have filed corresponding returns on time for this to apply. Also, debt discharge applies only to income taxes. Fraud penalties and payroll taxes are typically not discharged.
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You can save your home from foreclosure and your car from repossession
You can use Chapter 13 to stop home foreclosure, even if the foreclosure is currently in process. You’ll still have to make your mortgage payments, but you’ll get three to five years to catch up.
Chapter 13 also protects your car from repossession. You still have to pay your car loan, but you’ll have more time to do so, since the debt will be worked into your repayment plan.
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Your debt may be settled for less than you owe
If you have a no-asset Chapter 7 case, your unsecured debt will be discharged even if the creditor didn’t get paid. This includes debt due to personal loans, medical bills and credit cards. If you have assets to sell, whatever you get from the sale will be applied to your debt. Any eligible debt left over will be discharged.
With Chapter 13, you’ll have to pay your creditors, but you might not have to pay back your debt in full. If you have any debt left over after completing your repayment plan, it might be discharged.
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If you have bad credit, bankruptcy might improve your credit score
In some situations, filing for bankruptcy could improve your credit. It can lower your credit utilization and help you make (and afford) on-time payments on your bills since most, if not all, of your debt is discharged.
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You can apply for new credit once your debts are discharged
Once your bankruptcy case is closed and your debt is discharged, you’re free to apply for new credit — though it can be difficult to qualify. Products for people with poor credit history, like secured credit cards, can help. -
It wipes the slate clean
The prospect of life after bankruptcy can be daunting, but in some cases, bankruptcy can offer a fresh start. You might have an easier time changing your spending habits and budgeting for the future when you’re no longer under crushing debt.
The cons of filing for bankruptcy
If bankruptcy didn’t have negative consequences, it might become the first resort for those feeling overwhelmed by debt and looking for a fresh start. However, the reality is: There are many downsides to filing for bankruptcy. Learn what’s at stake before taking such a big step.
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You could lose your home under Chapter 7
If you have a lot of home equity and your home isn’t protected from sale, your trustee might choose to sell it. Many factors come into play when determining whether you can keep your house, such as your state’s homestead exemptions and whether you’re current on your mortgage payments.
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Bankruptcy can wreak havoc on your credit score
In some cases, if your credit score is low, filing for bankruptcy can improve it; but if you have good credit, prepare for a huge drop. Bankruptcy can cause some people’s credit score to drop by 100 to 200 points.
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Bankruptcy isn’t free
With lawyer and filing fees, bankruptcy isn’t cheap. Chapter 7 lawyer fees typically range from $1,000 to $1,700, but can run up to $3,000 depending on the case. Attorney costs for Chapter 13 generally range from $2,500 to $5,000. The filing fee for Chapter 7 is around $335; for Chapter 13, it’s around $310.
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Bankruptcy won’t discharge your federal student loans (in most cases)
The government has relaxed the rules around bankruptcy and student loans in recent years. Still, getting your federal student loans discharged through bankruptcy is a tall order.
To petition for discharge of your student loans, you must file something called an adversary proceeding and prove to the court that paying back your loans would cause undue hardship. The court gets to decide what an undue hardship is.
If you’re struggling to pay your federal student loans, it may be worth exploring forbearance, deferment or an income-driven repayment plan.
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You may still have to pay off some of your debt
Not all debts are eligible for discharge. Some common debts you must always pay back include child support, alimony and personal injury debts you accrued as a result of drunk driving.
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Cosigners may still be responsible for debt
Your cosigner may still have to pay the debt, even if you file for bankruptcy. Chapter 13 protects cosigners for consumer debt, like credit card bills. Chapter 7 doesn’t.
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Bankruptcy can take a long time
Chapter 7 bankruptcy usually takes from three to four months from initial filing to discharge, so it’s a fairly quick process. Chapter 13, on the other hand, requires a three-to-five-year repayment plan.
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You could lose your business
Unless you’re eligible for an exemption, you could lose your business through Chapter 7.
Factors involved in determining your exemption status include, among other things, the type of business you have (service-oriented versus product-oriented) and whether you’re a sole proprietor or an LLC/corporation. It’s also worth noting that your trustee probably won’t sell your business if it isn’t (very) profitable.
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You might be evicted if you’re behind on rent
Assuming you aren’t breaking any other terms of your lease, your landlord can’t evict you for filing for bankruptcy — that is, as long as you’re current on rent.
If you’re behind on rent and you’re filing Chapter 7, you could keep your place as long as you pay your future rent payments on time. You must also get caught up on your past-due payments within 60 days.
For Chapter 13, you need to work both your current and past-due balances into your payment plan. If you make your payments on time, you’re protected from eviction; however, if you miss payments, the landlord can request that the court lift the automatic stay protecting you from eviction.
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It could be hard for you to rent a new apartment or house
Some property management companies and private landlords automatically reject applicants with past bankruptcies. You’ll find it even more difficult to rent if the bankruptcy leads to an eviction. If it’s an option, you might want to wait to file for bankruptcy until you know you’re staying put for a couple of years.
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Bankruptcy could affect your career
Bankruptcy shouldn’t affect your current job. Employers can’t fire you because you filed for bankruptcy, and they can’t demote you for doing so, either. However, bankruptcy can impact future employment.
Many employers run a credit check on applicants. Employers can’t see your credit score, but they can see if you’ve filed for bankruptcy and how many late payments you’ve made. In some instances, the employer may choose not to hire you if you have a past bankruptcy, particularly if you work in a money-related field, like finance.
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Bankruptcy filings are public information
When you file for bankruptcy, it is published as public record. People can see if you’ve filed by using an online search tool called PACER (Public Access to Court Electronic Records).
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It may take time to qualify for a new credit card or loan
You might find it hard to get new credit when you have a bankruptcy on your credit report. (Chapter 7 stays on your report for 10 years and Chapter 13 stays on your report for seven years.) The lenders that are willing to extend credit may only offer you a secured card, which will require a deposit.
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Borrowing will be expensive for a while
When you do qualify for new credit, prepare for higher total loan costs and smaller borrowing amounts. Immediately after you file (or ideally, before), it’s time to rebuild your credit. This can help you nab lower rates when you’re ready to borrow again.
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You can’t get a home loan right away
To get a mortgage after bankruptcy, you must first go through a waiting period. To apply for a conventional loan, you’ll have to wait four years after your Chapter 7 bankruptcy. For Chapter 13, the waiting period is two years after bankruptcy discharge.
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Your car insurance premium will probably go up
In most states, car insurance companies can use your credit-based insurance score to calculate your premium. Your credit-based insurance score and your regular credit score aren’t the same thing. Even so, past bankruptcies negatively impact both.
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Bankruptcy won’t fix bad spending habits
In some cases, bankruptcy may just be a Band-Aid. If problematic spending habits got you into debt in the first place, you’ll need to develop new habits if you want to avoid having to file bankruptcy a second time.
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It’s not easy to cancel your bankruptcy after you file (and in some cases, it’s impossible)
If you want to cancel your bankruptcy after you file (but before discharge), the court must grant you a dismissal.
Chapter 7 cases that involve assets are generally difficult to get dismissed unless you can demonstrate good cause, such as a change in circumstances. It’s not enough to just change your mind. This is to stop people from backing out because they don’t want to sell property.
Chapter 13 cases are a little easier to get dismissed, but you’ll lose your automatic stay. Once dismissed, creditors can restart their collections process. They can also backdate late payment fees from the day the automatic stay was put into place.
You could face criminal charges if you’re dishonest in your bankruptcy filing. Lying or knowingly misrepresenting your financial situation is bankruptcy fraud. If convicted, you could spend up to five years behind bars, be charged a fine of up to $250,000, or both.
Who should not file for bankruptcy?
While bankruptcy can help some borrowers get a fresh start, it’s not for everyone. In fact, some people don’t qualify to file for certain types of bankruptcy.
For Chapter 7, the means test defines eligibility. It determines who can or can’t afford to repay their debts based on current monthly income and disposable income. You can do the means test calculation using IRS forms 122A-1 and 122A-2.
The higher your disposable income (i.e., the amount of money that’s available to you after necessary expenses), the less likely you’ll be able to file for Chapter 7 bankruptcy.
Instead, you may qualify for a Chapter 13 filing, in which you’ll repay your debts over a set period of time.
Bankruptcy may not be a good fit in certain scenarios, such as if you:
- Carry a high amount of nondischargeable debt, such as child support or alimony
- Had debts discharged in a prior bankruptcy case and have not yet reached the end of the waiting period
- Had a bankruptcy case dismissed in the last 180 days due to your willful failure to appear in court or comply with court orders
- Had a bankruptcy case dismissed in the last 180 days because the bankruptcy court granted a creditor the right to recover property on which they held a lien
Bankruptcy alternatives
There are other types of debt relief to consider before turning to bankruptcy. Many of them cost less and have less impact on your credit score than filing for bankruptcy.
Debt consolidation
Debt consolidation doesn’t reduce your debt; it reorganizes it. You’ll take out a debt consolidation loan and use it to pay multiple creditors. After that, you’ll have only one monthly loan payment to make. If you have good credit, debt consolidation loans usually come with lower rates than credit cards.
Debt consolidation makes the most sense if: You’re juggling multiple debt bills, you qualify for a better rate than you have now, and you can pay your debt in full.
Debt management plan
You’re required to go through credit counseling when you file for bankruptcy. There, a credit counselor will review your finances and help you create a budget. During the process, your counselor might find that you’re a good candidate for a debt management plan.
Like Chapter 13, a debt management plan will help you pay off what you owe in three to five years. Your credit counselor may also be able to negotiate with your creditors to get fees waived or rates reduced.
A debt management plan makes the most sense if you’re overwhelmed by debt but you want to avoid bankruptcy.
Debt settlement
Debt settlement is a risky type of debt relief. You’ll work with a third-party company that will attempt to negotiate with your creditors. The end goal is to pay less than what you owe.
However, there’s no guarantee that your creditors will be willing to negotiate. If they aren’t, you’re still on the hook to pay the debt settlement company. Also, you’ll likely stop paying your debts as the company negotiates. This can ruin your credit score.
Debt settlement may make sense if you have debt you can’t pay back, and you already have bad credit. Still, know the risks before pursuing this option.
Frequently asked questions
Filing for bankruptcy can cause your credit score to drop by 100 to 200 points. How much your credit score drops will depend on factors such as where your credit score stood before filing for bankruptcy. For instance, if you had excellent credit prebankruptcy, you may see a larger drop than someone who already had bad credit when they filed.
Many people see their credit improve 12 to 18 months after bankruptcy discharge.
A Chapter 7 bankruptcy filing stays on your credit report for up to 10 years, while a Chapter 13 filing remains for up to seven years. However, other factors can slowly increase your credit score over time, including on-time payments and not going into more revolving debt.
Yes, medical debt can be discharged through a Chapter 7 or Chapter 13 bankruptcy. However, you may also be able to pursue other debt relief strategies or negotiate with your medical providers before taking a bigger step like bankruptcy.
When you file a Chapter 7 bankruptcy, the money in your bank account is considered an asset and becomes part of the bankruptcy estate. That said, you will not automatically lose the money in your account as part of the bankruptcy process. If you owe the bank any debts, though, it may offset your account in the amount you owe.
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