When Bankruptcy Is Not a Dirty Word

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Lifesaver floating in the water

Bankruptcy is a legal process at the federal level that applies to a person (or company) who is no longer able to meet his or her financial obligations. Bankruptcy either eliminates or reorganizes the debt, and can eliminate some kinds of liens against the filer’s property. It has a long-lasting negative effect on the debtor’s credit and is generally considered an option of last resort. That doesn’t mean it’s never the best option.

First, some information.

Bankruptcy cannot erase all debts. Child/spousal support and criminal restitution are not subject to bankruptcy elimination. Nor are debts that the filer forgets to list on the bankruptcy papers, or debts acquired after the individual files for bankruptcy protection. Student loans can technically be discharged in a bankruptcy, but it’s rare. Other debts that are typically not subject to bankruptcy protection include debts obtained fraudulently and debts caused by criminal action (such as drunk driving) or other willful harmful acts. Bankruptcy does not relieve cosigners of legal obligation to pay cosigned debts.

Also, any creditor can argue to have a debt excluded from the bankruptcy, and sometimes they prevail. Recent large debts (within 90 days before filing) to any one creditor and large cash advances (within 70 days before filing) are usually not discharged.

The most common types of bankruptcy for individuals are Chapter 7 and Chapter 13.

Chapter 7 Bankruptcy

Chapter 7 is a liquidation process. Debts are eliminated after certain assets are sold in order to lower the balances. Some property, such as the individual’s clothing, furniture and vehicle (up to a certain value) is exempt from the process and not subject to seizure and sale. In many cases, the primary residence is also exempt. The bankruptcy does not, however, erase the debt associated with the assets the filer is allowed to keep. In other words, the debtor may be allowed to keep his car and home, but must continue to pay the auto loan and mortgage as agreed.

Chapter 7 bankruptcy typically eliminates credit card debt, medical bills, unsecured loans and past due bills to service providers. Some tax debts can be discharged if the debtor satisfies certain conditions.

Chapter 13 Bankruptcy

Chapter 13 is a reorganization process. The filer continues to hold responsibility for repaying the debts for the repayment period specified (usually three to five years) and under the supervision of the court. (At the end of the repayment period, some remaining unsecured debt balances can be eliminated.) No property is seized or sold because the reorganization depends on the filer’s income. The filer must prove sufficient income to cover all of the required debt payments, including any extra payments needed to get caught up on late accounts.

A Chapter 13 bankruptcy can stop a foreclosure and force the mortgage holder to accept a court-approved payment plan. Also, in some cases Chapter 13 can be used to reduce the amount of debt owed. For example, if the filer owes more on a vehicle than it is worth, he can ask that the loan balance be reduced to the replacement value of the vehicle. This is called “cramming down” the debt.

Consequences of Bankruptcy

Debt relief. Debt is vastly reduced or eliminated altogether. Debtors get a financial fresh start and/or a viable short-term debt repayment plan.

Credit. Bankruptcy is one of the most serious negative events that can appear on a consumer’s credit report card. It remains for seven (Chapter 13) to ten (Chapter 7) years. Many creditors and employers will automatically disqualify an applicant whose credit history includes a bankruptcy. For debtors facing multiple collection accounts, charge-offs and other negative credit events, bankruptcy is not significantly more detrimental. The negative effect on the consumer’s credit score diminishes over time; the process to rebuild a healthy credit score can commence immediately upon bankruptcy discharge.

Loan eligibility. Debtors whose bankruptcy renders a government-backed loan (FHA or VA mortgage, for example) not fully repaid may not be legally obligated to repay the debt, but won’t be eligible for a new government-backed loan until it is paid off.

Credit relationships. Some creditors may stop doing business with a bankruptcy filer until all past debts are repaid, despite the fact that after bankruptcy discharge the debtor is not legally obligated to repay the debts.

Discharge moratorium. After a bankruptcy discharge, a person is not eligible for another discharge for several years.

– Two Chapter 7 filings – ineligible for second discharge if filed within eight years of first filing

– Two Chapter 13 filings – Ineligible for second discharge if filed within two years of first filing

The waiting periods are slightly different when the new filing is under a different chapter. They range from four to six years and numerous exceptions apply.

When is bankruptcy a good option?

Because of the long-lasting effects on the consumer’s credit, bankruptcy is something to approach cautiously. Also, it’s not free. Somewhat ironically, the filer will need to come up with sufficient cash to get through the process, typically by hiring a bankruptcy attorney.

Some factors to consider:

Negative cash flow or insolvency. If your monthly bills regularly exceed your income and you have exhausted all options for payment arrangements, exploring bankruptcy may make sense. Some signs that point to bankruptcy as a viable financial option include:

– Can’t get caught up on bills

– Takes payday loans or cash advances to cover basic living expenses

– Pays for basic expenses with a credit card and can’t afford to pay off the credit card

– Received notice of foreclosure or repossession

Insolvency means the total debt exceeds the market value of all the assets.

Property. A person with unsecured debt (not for taxes, child/spousal support or student loans) and little or no assets or income that creditors can seize or garnish may not get much benefit from bankruptcy; there’s nothing for creditors to go after anyway. For someone who owns property and assets, each state sets its own limits on what is exempt. A bankruptcy attorney can help maximize exemptions and protect property from seizure. For example, in some states spouses filing together can claim double the exemptions. But a person who doesn’t want to risk losing property may need to explore options other than bankruptcy.

Type of relief sought. If all or a large portion of your debt is likely to be considered not dischargeable (child support, some student loans, recent unpaid taxes, recent debts that the court will ignore, legal judgments against you and so on),  bankruptcy may not help.

Exhausted other options. Consumers who feel crushed by debt should start by talking with a certified, government-approved debt counselor. Oftentimes, the debt can be reorganized outside of bankruptcy and on a three to five year plan. Furthermore, financial counseling is required by the bankruptcy court.

Willingness to change. Debtors who file for bankruptcy protection have a unique opportunity to turn their financial lives around. If the bankruptcy is brought on by unsecured debt like credit cards, the consumer must make a commitment to handle money and debt more responsibly in the future. Otherwise, bankruptcy simply becomes a revolving door.

Image: (cc) Alachua County

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Published June 3, 2015 Updated: April 20, 2016
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