Filing for personal bankruptcy is a major decision with implications for everything from where you can live, your ability to get a job, and even your personal relationships. But it also gives you the ability to resolve your debts by discharging them completely or following a court-ordered payment plan.
In this guide we’ll answer the top 7 questions we’ve been asked about bankruptcy.
1. Should I Keep Paying Off Debt or Go Bankrupt?
Because bankruptcy can have so many serious known and unknown ramifications on your life, you should first thoroughly consider your other options, including renegotiating debt outside of bankruptcy.
For example, most federal student loans are eligible for income-based repayment, or IBR, which caps your monthly payments at a fixed percentage of your monthly income after certain deductions.
Private student lenders may also be willing to defer payments in the case of personal hardship.
Unsecured lenders like credit card companies and hospitals that know they’ll receive little or nothing if you file for bankruptcy, so they may be willing to settle your account for less than the full amount you owe.
Unfortunately, they may only be willing to negotiate once you’ve missed several payments.
Between the missed payments and the mark on your credit report that the account was settled for less than the amount owed, your credit score is likely to take a serious beating if you go this route.
In other words, a bankruptcy hit to your credit may not be much worse.
Once you’ve decided to file for bankruptcy, you should immediately stop making payments on the debt that you plan to discharge. That’s just throwing good money after bad.
2. What’s the Difference between Bankruptcy and Debt Management Plans?
If you are unable to pay your bills, you may start to receive mail or phone calls from companies offering “debt management plans.”
Debt management plans are privately negotiated agreements between creditors, lenders, and the debt management company.
The goal of a debt management plan is for creditors to be repaid, and for debtors to avoid bankruptcy.
The key difference between bankruptcy and a debt management plan is that bankruptcy is a legal process, overseen by a judge and administered by a bankruptcy trustee, with the goal of discharging debts that a debtor is unable to repay, while a debt management plan is a privately negotiated agreement, sometimes administered by a for-profit company, with the goal of repaying creditors and avoiding bankruptcy.
Unlike bankruptcy, a debt management plan won’t discharge your debts or give you the legal right to stop calls from debt collectors.
A debt management plan may be right for you if you have fallen behind on repaying your debts, but you think you will have enough income to repay your debts in the next 3-5 years.
Under a debt management plan, lenders may agree to reduce or eliminate late fees and penalties your accounts have incurred in order to receive full repayment.
Lenders may also agree to a lower interest rate on the remaining debt.
Secured debts can’t be brought into a debt management plan, so if you only have secured debts like car loans or home mortgages, a debt management plan won’t help you get caught up.
Student loans also won’t be included in a debt management plan.
Be realistic about your ability to repay your debts. If you have no chance of earning enough money to repay your debts in full, don’t enter into a debt management plan, since it will only prolong your pain before you ultimately file for bankruptcy anyway.
A certified credit counselor can help you decide which option is best for your situation. Start at the NFCC’s website to find a counselor in your area.
3. What are the Different Kinds of Personal Bankruptcy?
Once you’ve decided to file for bankruptcy, you need to decide whether to file for Chapter 13 or Chapter 7 bankruptcy.
A Chapter 13 bankruptcy is designed to let you keep your assets, while settling your debts with your creditors by negotiating a payment plan that lasts between 3 and 5 years.
At the end of the payment plan, your remaining debts are discharged, unless you’ve reaffirmed (promised to pay) your secured debts and received the approval of your bankruptcy judge.
In a Chapter 7 bankruptcy, your assets (with some exceptions) are liquidated and used to repay your creditors. At the end of the process, all of your debts are discharged.
Liens against collateral used to secure debt, like car loans and home mortgages, will not be discharged, and that property can be repossessed or foreclosed on unless you continue to make payments or are able to reach a new agreement with your lender.
4. How to Decide between Chapter 13 and Chapter 7 bankruptcy
A bankruptcy attorney licensed in your state can help you sort through these and other issues related to filing for bankruptcy.
It may seem counterintuitive to pay for help if you can’t afford to pay your bills, but professional help may get you better results than you can get on your own.
First, you must determine if you’re eligible to file for Chapter 7 bankruptcy.
Eligibility for Chapter 7 depends on your “ability to pay,” which is based on your income in the preceding 6 months and the median income in your state.
If your income in the preceding 6 months was lower than the median income in your state, you’re eligible for Chapter 7.
If it was higher, you may still be eligible, but will need to do some additional calculations to know for sure. You can start with an online means test calculator.
Additionally, in order to file for Chapter 7 bankruptcy, you must not have filed for Chapter 7 bankruptcy in the last 8 years or Chapter 13 bankruptcy in the past 6 years.
Even if you’re not eligible for Chapter 7 bankruptcy, you are probably still eligible for a Chapter 13 bankruptcy filing.
In Chapter 13 bankruptcy, your debts are reorganized and a payment plan is developed that will bring your payments in line with your ability to pay. At the end of the payment plan, your remaining debts are discharged.
In order to be eligible for Chapter 13 bankruptcy, you must not have already filed for Chapter 13 bankruptcy in the past 2 years or Chapter 7 bankruptcy in the past 4 years.
Besides eligibility, the next most important consideration in deciding which kind of bankruptcy to file for is the amount of equity you have in your home and whether you intend to continue making mortgage payments.
That’s because in a Chapter 7 bankruptcy your “nonexempt” home equity — the amount of equity you have in your home in excess of your state’s homestead exemption — can be used by the bankruptcy trustee to pay off your other creditors, which unfortunately involves selling your house.
In a state with a high or unlimited homestead exemption you may be able to keep your house if you own it outright or if you keep up your mortgage payments.
If you have little equity in your house, or live in a state with a low homestead exemption, a Chapter 13 bankruptcy may allow you to keep your home or car by continuing to make on-time payments according to the terms of your original loan, and making up any missed payments according to your Chapter 13 payment plan.
After you exit bankruptcy, your lender can’t foreclose on your home or repossess your car as long as you continue to make your payments on time.
5. Does Bankruptcy Hurt Your Credit Score?
Bankruptcy appears on your credit report as a derogatory remark, and all else being equal has a strong negative effect on your credit score.
In other words, a person with a perfect credit score who suddenly files for bankruptcy will see his credit score immediately crash.
In reality, by the time most people file for bankruptcy they have already fallen behind on their payments, gone into default or foreclosure, or had legal judgments entered against them.
Those negative marks will have already ruined their credit score, and bankruptcy may or may not reduce it any further.
According to Credit Sesame’s data, users with a bankruptcy on their credit report actually have slightly higher credit scores, on average, than users with negative marks like tax liens or legal judgments against them.
That’s partly because consumers with bankruptcies on their credit report are scored differently than users without bankruptcies; a bankrupt consumer with a sterling record of on-time payments may have a higher credit score than a person on the verge of bankruptcy who has dozens of missed payments, charge-offs, collections, and liens.
6. How Long Does a Bankruptcy Stay on Your Credit Report?
How long a bankruptcy will stay on your credit report depends on which chapter of the bankruptcy code you decided to file under.
A Chapter 13 bankruptcy remains on your credit report for 7 years from the date of your filing.
A Chapter 7 bankruptcy filing remains on your credit report for 10 years.
7. How to Rebuild Credit after Bankruptcy
Building credit after bankruptcy takes time, but it can be done.
First, request a credit report and review it carefully to make sure that all the debts you discharged in bankruptcy have been properly reported on your credit report.
The law entitles you to one free copy of your credit report every twelve months from each of the major credit bureaus. You can access these free copies at AnnualCreditReport.com. You can get them all at once or one at a time.
To see how you’re doing in each of the major factors that affect your credit score, look at your free credit report summary on Credit Sesame.
If you want to see your credit reports more often, you can access one or all three on Credit Sesame for a fee.
Lenders are prohibited from trying to collect on discharged debt, including by incorrectly reporting your loans as past due or charged off in order to coerce you into paying.
Second, reestablish good credit habits as soon as possible.
Since most student loans won’t be discharged in bankruptcy unless the bankruptcy judge determines you would face undue hardship if forced to repay them, make all student loan payments on time and ensure the payments are shown correctly on your credit report.
Consider opening one or more low-fee secured credit cards in order to establish a history of on-time payments (and be sure to pay your bills in full in order to avoid interest charges).
You may be able to take out a car loan a year or two after filing for bankruptcy.
If your credit score leaves you with a high interest rate on your car loan, borrowing just a small amount of the car’s purchase price is a way to establish another trade line on your credit report that can report ongoing payments.
Finally, the most important key to rebuilding your credit is patience.
Your discharged loans may drop off your credit report before the bankruptcy itself, depending on how long you waited to file after falling behind on payments.
Then either 7 or 10 years after filing for bankruptcy, the filing itself will drop off your credit report and, assuming you’ve maintained a history of on-time payments on multiple tradelines, your credit score should see an immediate boost.