Updated – November 14, 2018
If you’re drowning in debt and having trouble keeping up with your payments while still handling your living expenses, you may have at least begun to consider filing for bankruptcy.
Filing for bankruptcy is meant to give people in serious financial distress some relief and a chance to start over. By the time most people get to that point, they’ve probably tried many other methods for managing their debt.
Bankruptcy certainly has its benefits, potentially allowing you to wipe the slate clean and start anew.
But there are a lot of things to consider before making a decision, from the negative consequences of filing to whether bankruptcy would even provide relief for your specific situation.
“For most folks that come in, this is the last option,” said John Colwell, a San Diego, Calif.-based bankruptcy attorney and President of National Association of Consumer Bankruptcy. “I know I’m like the dentist. People really don’t want to be sitting in front of me.”
This is a big decision that requires a significant amount of due diligence before moving forward. While it’s important not to take bankruptcy lightly, it may be the best way for people to get back on their feet.
So how do you know if bankruptcy is the right way to relieve your debt? In this post, we’ll go over some of the key points to help you get started.
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The basics of filing for bankruptcy
Bankruptcy is a legal procedure to discharge debt built up by someone who either will not be able to repay those debts or does not have the means to repay debts owed currently. There are two notable forms of bankruptcy: Chapter 7 and Chapter 13.
In a Chapter 7 bankruptcy, a debtor’s nonexempt assets are sold and the proceeds are used to pay debts. An individual must pass a means test before they can file a Chapter 7 bankruptcy to ensure that the court would not be abusing the bankruptcy law by granting one. We will talk more about the means test below!
A Chapter 13 bankruptcy is a “wage earner plan.” To qualify, an individual must have a steady income. This allows them to pay back all or part of their debts by developing a repayment plan. The plans last between three and five years.
In most cases, bankruptcy does not protect you from any future debts incurred. It also will have an effect on your credit score and remains on your credit report for 10 years with Chapter 7 and seven years with Chapter 13. In a Chapter 7 bankruptcy, you may lose assets such as your house or your car depending on how much equity, if you’re able to exempt your equity and if you’re current on your payments.
Are You Eligible?
As stated above, there are two types of bankruptcy for individuals: Chapter 7 and Chapter 13.
There are some significant differences between the two programs, but here’s a high-level summary:
- Chapter 7 allows you to completely discharge your debts, with some exceptions (such as student loans, certain tax obligations, and child support). But you may be obligated to sell some of your property to settle some of your debt obligations.
- Chapter 13 allows you to create a payment plan to repay some or all of your debts over a 3-5 year period. So your debts are not discharged, but you will also not be obligated to sell any property in order to make your payments.
Either one could be more or less beneficial depending on the specifics of your situation. But the very first question is whether you qualify for either one, and each has its own set of criteria.
Chapter 7 bankruptcy has what’s called the “means test”, which is meant to ensure that only people who truly can’t afford their debt payments are allowed to file. There are two different wants to pass it, and therefore qualify for Chapter 7 bankruptcy:
- If your monthly income is less than the median monthly income in your state for your family size, you pass. You can find current median income numbers by family size here.
- If you don’t pass #1, you’ll have to go through a complex calculation to see whether your disposable income after subtracting out certain expenses is enough to satisfy your debt obligations. At this stage it would probably be best to talk to a professional who could help you navigate the process.
Eligibility for Chapter 13 bankruptcy is a little more straightforward. Here’s how it works:
- As opposed to Chapter 7, you need to prove that your disposable income is high enough to afford a reasonable repayment plan.
- Your secured debt (mortgage, auto loan) can’t exceed $1,149,525, and your unsecured debt (credit cards, medical bills, etc.) can’t exceed $383,175.
- You must have filed both federal and state income taxes each of the last four years.
There are some other requirements for each, but those are the major ones. Assuming you qualify for at least one of them, there are a few other things to consider.
What Kinds of Assets and Liabilities Do You Have?
Depending on the specifics of your financial situation, one type of bankruptcy may be preferable to the other. Or it may be that neither would actually be particularly helpful.
As an example, neither type of bankruptcy would likely help you all that much if your primary debts are student loans. They wouldn’t be discharged in Chapter 7 bankruptcy. And while your required payments might be reduced over the 3-5 year repayment period in Chapter 13 bankruptcy, once that was over you would have to continue paying them back as usual.
The type of assets you own and their value also matters, particularly if you’re going through Chapter 7 bankruptcy. During that process, your bankruptcy trustee is allowed to sell your property in order to settle your debts, but certain property is protected.
For example, your house and car are protected up to certain limits. Employer retirement accounts like 401(k)s and 403(b)s are fully protected, while IRAs are protected up to about $1 million. But other accounts, such as checking, savings, and regular investment accounts may not have the same protections.
The rules here vary by state, and having a strong understanding of which assets you might be able to keep and which you might end up losing will help you make your decision.
When to file bankruptcy
According to Colwell, filing for bankruptcy needs to be “worth your while,” meaning it should give you relief from your debts to ensure you don’t find yourself in a similar situation in the near future. That means that if you have major expenses that you are about to incur, you should wait to file until after you have incurred them so they can be included in the bankruptcy settlement. This is especially important when it comes to filing bankruptcy due to medical bills.
However, with a Chapter 13 bankruptcy, you can seek court approval to include new debt that you’ve incurred post-filing into your payment plan.
In general, though, there are aspects of your financial situation that signal when it’s time to consider bankruptcy. If you can’t pay your bills (and you don’t see that changing anytime soon) and your debt continues to pile up, bankruptcy is probably worth considering.
Here are other red flags to look out for:
- Debt collectors are calling. If you’re behind on your bills to the point that you’re hearing from debt collectors, it may be time to consider bankruptcy. This is especially true if you’re being sued by debt collectors.
- You’re in danger of losing your home. If you’re at risk for losing your house to foreclosure, filing bankruptcy can help you get caught up on your payments and keep your home. With Chapter 13, you’re given the chance to keep your home by creating a plan to repay your outstanding debt.
- You’re using loans to pay your bills. Using short-term high-interest loans such as payday loans can get you in trouble. With these loans, people borrow against their next paycheck. “People get caught in the trap and it starts rolling over from paycheck to paycheck to paycheck,” said Colwell. Title loans are another form of small loan where a vehicle is used as collateral; these loans can be problematic for someone already in financial distress.
- You’re liquidating your retirement assets. Retirement money is exempt in a bankruptcy, meaning trustees can’t use it to repay lenders. So in most cases, it doesn’t make sense to burn through your retirement money to pay debts. “I hate that with a passion,” Colwell said. “It’s your retirement money, what are you doing?!”
How to file for bankruptcy
Most initial consultations with lawyers are free of charge. At these meetings, you’ll walk a bankruptcy attorney through your financial situation and your reasons for wanting to pursue bankruptcy.
There are also ways for individuals to file for bankruptcy on their own, known as filing pro se. Court employees and bankruptcy judges can’t give out legal advice to people in their courts, so if you go that route, you will be on your own. To file yourself, you should be familiar with the United States Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and the local rules of the court.
Unless you have a strong understanding of legal issues and have the time to handle the paperwork, it’s probably best to use a lawyer — that’s because making a mistake can impact your rights, according to the U.S. Courts. You’ll also need the capacity to fill out a lot of paperwork, Colwell also noted.
If you use an attorney, they should be able to provide services including:
- Advising you on whether to file a bankruptcy petition and under which chapter to file.
- Telling you whether your debts can be discharged.
- Advising you on whether or not you will be able to keep your home, car, or other property after you file.
- Advising you of the tax consequences of filing.
- Advising you on whether you should continue to pay creditors.
- Helping you complete and file forms.
How to file Chapter 7 bankruptcy
A Chapter 7 bankruptcy involves the sale of all of your nonexempt assets to pay back your creditors. This is the most common kind of personal bankruptcy, accounting for more than 60 percent of all non-business bankruptcies in 2017. The process usually takes about four to five months.
Filing for Chapter 7 will wipe out your allowable debt (such as as credit card, medical and personal loan debt), but the bankruptcy will remain on your credit report for up to 10 years.
The first step is to take a mandatory credit counseling course from a government-approved organization, within 180 days of your filing date. Upon completion, you can decide if you still feel it appropriate to move forward with a bankruptcy, and move on to the next step.
At this point, you, or your attorney, would file your petition and other additional forms with the court. Along with your filing petition, the forms include a list of your creditors, a summary of your assets and liabilities, lists of property (both exempt and non-exempt) and any documentation needed for your “means test.” There are also companies that will send you a packet of all relevant documents, for a small fee.
At this point, you will be subject to the “means test.” If the debtor’s current monthly income is more than the state median, the means test is applied. Abuse is determined if the debtor’s monthly income over five years is either more than $12,850, or more than 25% of the debtor’s nonpriority unsecured debt of at least $7,700.
A trustee is then appointed to review the paperwork and take nonexempt property; you will also have to submit your most recent tax return to the trustee.
The next step in the process is a meeting of creditors, known as a “341 meeting.” At the meeting, you will answer questions about your finances and bankruptcy forms under oath. Creditors are allowed to attend the proceedings if they choose.
It is now decided if you are eligible to file for Chapter 7. At this stage, secured debts are determined: they can be repossessed by the creditor, you can redeem it by paying back what it’s worth or you can reaffirm the debt, which removes that debt from the bankruptcy filing and allows you to pay it back when the bankruptcy is over.
You will have another course to attend that will include information on developing a budget, using credit and managing money — afterward, your debt will be discharged.
Cost: A Chapter 7 bankruptcy needs to be paid for upfront by the debtor. It is generally a flat rate and may be contingent on the complexity of your debt structure as well as the market in which the attorney is operating.
How to file Chapter 13 bankruptcy
A Chapter 13 bankruptcy will last between three and five years, from start to finish. These processes are long and complex, so it’s strongly recommended that you use a lawyer. If you have a steady income, Chapter 13 bankruptcy allows you to keep property, like a house or car, that you might otherwise lose in Chapter 7. Chapter 13 develops a three-to-five year repayment plan for your debts.
The first step is to take a credit counseling course. Afterward, you or your attorney will prepare and file a bankruptcy petition and paperwork that includes a list of your creditors, a summary of your assets and liabilities and your Chapter 13 repayment plan; you will also need to provide your most recent tax returns.
The court will later appoint a trustee to administer your case and a stay on collections will take effect — this means that certain creditors won’t be able to proceed with lawsuits against you, call you for repayment or garnish your wages. You’ll begin making payments for a month after you file the paperwork. In addition, like Chapter 7, Chapter 13 also requires a 341 meeting.
You or your lawyer must attend a confirmation hearing where objections to your plan either by the trustee or the creditors will be addressed and eventually your plan for repayment will get confirmed.
Your creditors will also file proof of claim so that they can get repaid; it is at this point that you can object to the claim if you feel it is unfair.
The repayment period begins when you start to comply with your plan’s requirements and payments; this is the longest portion of the bankruptcy. If required by your plan, you may also have to submit documents to the court like income and expense statements.
Exactly as in Chapter 7, you’ll have another course to attend that goes over budgeting, using credit and managing money. Afterward, your debts may be discharged and your case closed.
Cost: There are two ways an attorney can charge you for handling your Chapter 13. It may be a “no look” fee, a flat fee set up by the district in your state, or they can bill you hourly. Your payment to your attorney can be worked into your Chapter 13 repayment plan.
Filing for bankruptcy is a big decision, and in the end you’re the only one who will know what’s right for you.
Bankruptcy can be not only a long process, but also a very emotional one for those seeking to discharge debts.
Do your research, evaluate all of your options, and then make the decision that most helps you reach your personal goals.
Looking into your options sooner rather than later may help you shore up your financial future and lose less in the long term.
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