When should I file bankruptcy?

Consider the signs that it might be time to seek legal debt relief

Most of us feel a moral obligation to pay what we owe. In general, that’s a good thing. It helps us try only to spend what we can afford and meet our end of any agreements we’ve made. But there are times when circumstances are more complicated than we imagined. Maybe you had a major medical emergency and now owe the hospital thousands of dollars that you don’t have. Or maybe your business went under and you still owe money to the bank. And if your finances have really suffered due to the COVID-19 crisis, the pressure you’re probably feeling right now is even more intense. You may be wondering if you should file bankruptcy to improve your financial situation.

Financial stress is exhausting. And bankruptcy is meant to give you a chance to start over. With a recession looming due to COVID, bankruptcies will likely rise — maybe even double, just like they did following the 2008 recession. According to debt.org, personal bankruptcies are expected to skyrocket in the second half of this year after government intervention (in the form of the CARES Act) fades. If you’re struggling and considering filing for bankruptcy yourself, read on for information that can help you navigate the decision. 

Signs that bankruptcy might be right for you

Pros and cons of bankruptcy

Top reasons people file for bankruptcy

Alternatives to bankruptcy

What is bankruptcy? Differences between Chapter 7 and 13  

How to file for bankruptcy

Signs that bankruptcy might be right for you

If you’re considering filing for bankruptcy, it’s probably because you’re experiencing one or more of the signs listed below. (But before we dive in, an important note: If you’re experiencing some of the below, don’t wait too long to file. If you do, you may not have enough money to initiate the process or you may lose out on protecting your retirement accounts from creditors.)

• Your debt-to-income ratio (DTI) is approaching or exceeds 2.5. (For example, your credit card debt is $85,000 but you earn $35,000/year (ratio of 2.4) and have no realistic way of improving your income in the next few years.)

• You’re repeatedly using loans or credit cards to pay for essentials such as food, utilities, and rent.

• You’re getting calls from multiple debt collectors and possibly court judgments. 

• You’ve spent everything you had in savings and 401k plans (or are about to).

• Your age requires that you’re saving to support yourself in your retirement years and have no realistic way of paying your debt off. 

Pros to bankruptcy

You can end collection calls via “automatic stay”

An automatic stay halts almost all bills, calls, and collection letters, including lawsuits and wage garnishment.  

You can reduce your level of stress

Financial stress and constant hassling from creditors is bad for your mental, physical, and emotional health.

You can start saving again

First your emergency fund, then for a house down payment or retirement. 

You’ll get new credit within a couple of years  

Most people’s credit is in pretty bad shape by the time they file for bankruptcy. Once you file, scores actually tend to rise, not fall. If the debt is erased or “discharged” credit scores often go up.

It’s not uncommon for people with steady incomes and good financial behavior post-bankruptcy to be granted new credit lines within 18 months.

Cons to bankruptcy

Some debts can’t be erased with bankruptcy 

Although bankruptcy can help you start fresh, there are many debts it won’t erase, including child support, recent tax debt, and student loan debt (in most cases). 

Attorneys want to be paid upfront 

Typically fees range between $2000-$4000. If you’re really strapped, call the bankruptcy court in your area to find out what resources are available. There are some pro-bono services available but they are typically overwhelmed by demand.  

Your credit score will take a hit and a while to recover

Your credit score won’t likely fully recover until the bankruptcy drops off your credit report after seven years (chapter 13) and 10 years (chapter 7).  But if you’re considering bankruptcy, chances are high your credit is already in pretty bad shape.

You’ll pay higher interest rates on just about everything while your credit score recovers 

If you have bad credit or have filed for bankruptcy, people are less willing to lend to you again. Or if they do, they’ll charge you an arm and a leg. 

Top reasons people file bankruptcy

In 2019, there were 750,878 personal bankruptcy filed nationwide in the United States, according to US Federal Judiciary, with the majority being Chapter 13. Here’s why so many people filed:

1. Medical Expenses

Most families don’t have enough saved to cover an emergency, let alone thousands of dollars in unexpected medical costs. The American Journal of Public Health said medical debt remains the number one cited reason for bankruptcy.

2. Reduced Income

You may be employed but not earning the same salary you were a couple of years back when you made a set of financial decisions. Companies are under constant pressure on shareholders and actively seek ways to reduce expenses — including payroll costs. This can often translate to reducing layers of middle management,  relocating jobs, pay cuts, or reductions in bonuses. 

3. Job loss

Job losses quickly deplete savings and make it difficult to plan or save. Even if you’re lucky enough to get severance, the number of weeks will pass quickly. And, you may be paying out of pocket for your own health insurance. 

4. Credit card and loan debt

It’s all too easy to get approved for another credit card or loan. The average credit card holder has at least four cards with an average of $8,398 in credit card debt, according to debt.org. Irresponsible spending is one cause, but debt can also pile up due to emergencies like illness and job loss. 

5. Divorce

Separation means a reduction in shared income and expenses for both partners. This could mean taking on a portion of your partner’s debt if you co-signed or opened joint accounts with them.

6. Emergencies

Many Americans don’t have emergency savings to account for small events, much less anything saved up to handle large emergencies such as a lawsuit/legal fees, theft, or catastrophic weather damage 

7. Student Loans

Student loans are difficult to get out of, but you may be able to have them discharged if you can prove undue hardship. You must prove that payment of the debt will prevent you and your dependents from having a minimal standard of living if forced to repay the loans.

You may also be able to get your student loan debt discharged if you can prove you didn’t benefit from the education or went to a fraudulent school.

8. Foreclosures

If you’re behind on your mortgage payments with no feasible way to get current before foreclosure, the only way to keep your home is to file a Chapter 13 bankruptcy. More than one percent of Americans have to file for bankruptcy each year to avoid foreclosure on their homes.

Alternatives to bankruptcy 

Declaring bankruptcy has significant and long-ranging effects, so you consider all possible alternatives first. Ask yourself the following questions and if you answered positively to any of them, bankruptcy might not be the right choice just yet.

Is your situation temporary?

Consider whether or not your financial problems are temporary. For example, if you just lost your job, will you qualify for unemployment benefits? Will you be able to get a new job?  Can you level up your skills and experience to get a better job? 

Can you pick up a side job to pay down your debt? 

Working an extra shift or the weekend is not a fun path, but maybe worth it for a year if it pulls you out of debt. There are many side gigs available to earn extra cash. 

Have you been following a budget? 

Many people don’t have a budget. They keep the math in their head, which doesn’t count. You may know what you pay for the essentials each month — rent, car payment, and insurance, etc. but put it down on a spreadsheet or try a budget tool like Mint. Then track the non-essential expenses. This is where a lot of people get themselves into trouble. 

Do the bulk of your debts come from taxes owed, court judgments, or student loans?

Bankruptcy treats debts differently. Taxes, court judgments, child support, and student loans are examples of debts that can’t be erased in bankruptcy in most cases. In such cases, bankruptcy is probably not right for you. 

Is credit counseling and debt consolidation a better path for you? 

Debt consolidation is the combination of several unsecured debts — payday loans, credit cards, medical bills — into one monthly bill. If you go this route, seek a reputable firm and check the math carefully.

It’s vital you understand the risks of debt consolidation and the best options for you. In reality, many companies promise lower interest rates and one monthly payment, but you end up paying more money over time and stay in debt longer. 

What is bankruptcy? 

Bankruptcy is a legal procedure to “discharge” (get rid of) debt that you won’t be able to or don’t have the means to repay. There are two forms of personal bankruptcy: Chapter 7 and Chapter 13.

A Chapter 7 bankruptcy

Before you can file for Chapter 7, you must pass a “means test,” which looks at your income, expenses and family size to determine whether you have enough disposable income to repay your debts. A Chapter 7 filing remains on your credit report for 10 years.

A Chapter 13 bankruptcy

To qualify, you must have a steady income. This allows you to pay back all or part of your debts by developing a repayment plan. The plans last between three and five years. A chapter 13 bankruptcy also remains on your credit report for seven years.

Chapter 7 and 13 Compared

	Chapter 7	Chapter 13
Type of Bankruptcy	Liquidation	Reorganization
Who can file?	Individuals and business entities	Individuals only (Including Sole Proprietors)
Eligibility restrictions	Disposable income must be low enough to pass the Chapter 7 Means Test	Cannot have more than $419,275 of unsecured debt or $1,257,850 of secured debt (as of April 2019)
How long does it take to receive a discharge?	Typically three to four months	Upon completion of all plan payments (usually three to five Years)
What happens to property in bankruptcy?	A trustee can sell all non-exempt property to pay creditors	Debtors keep all property but must pay unsecured creditors an amount equal to the value of non-exempt assets
Allows removing unsecured junior liens from real property through lien stripping?	No	Yes (If requirements are satisfied) (Learn about lien stripping.)
Allows reducing the principal loan balance on secured debts?	Yes, but on tangible personal property only (Learn about redemption.)	Yes (If requirements are satisfied) (Learn about cramdowns in bankruptcy.)
Benefits	Allows debtors to quickly discharge qualifying debts and get a fresh start	Allows debtors to keep their property and catch up on missed mortgage, car, and nondischargeable priority debt payments
Drawbacks	A trustee can sell the non-exempt property. Does not provide a way to catch up on missed payments to avoid foreclosure or repossession.	Must make monthly payments to the trustee for three to five years. May have to pay back a portion of general unsecured debts.
Credit report	Remains for 10 years	Remains for seven years

How to file bankruptcy

If you’ve made up your mind to go the bankruptcy route, here’s a high-level overview of the process.

1. Find a good attorney

Find an attorney who is experienced with bankruptcy law. Your state bar association should have directories with bankruptcy attorney information. There are also online directories, such as the National Association of Consumer Bankruptcy Attorneys and the American Board of Certification.

Look for one who offers a free consultation to help you confirm your decision. Once you sign on with the attorney, expect fees to range between $1200 and $4000. Some attorneys will allow this as part of a repayment plan. 

2. Have a bankruptcy counseling session

Your bankruptcy may include bad luck, but everyone can sharpen their financials — especially as you get back on your feet to build your future. You’ll have two mandatory credit counseling sessions with an agency that is approved by the U.S. Justice Department.

The first round of pre-filing counseling happens before you file bankruptcy paperwork with the courts. The counselor will want to review your budget and make sure you understand the pros and cons of bankruptcy, as well as alternatives. The second session happens after your debt is discharged (see below). 

3. File for bankruptcy with the court  

Now you file with the court and the bankruptcy is on your credit report. The good news is that creditors must stop attempts to collect on your debt. The reason why creditors are prohibited from contacting you is that bankruptcy invokes an “automatic stay,” which stops all legal activities from taking place the moment the bankruptcy is filed.

• Chapter 7 is faster with the entire process taking between four and six months to complete, including discharge.
• Chapter 13 generally takes 95 days from the filing of the petition to the approval of the repayment plan. The discharge of the bankruptcy occurs three to five years later once your payment plan is complete. 

4. Begin your repayment or liquidation plan

The next step is paying either repaying a portion of your debt (Chapter 13) or liquidating what you have to repay your creditors (Chapter 7). 

If you file a Chapter 7 and have no large value assets, it is called a “No Asset Case,” and the courts won’t sell your property. During the planning process with your attorney, you’ll be able to identify and secure debts that you want to keep.

Secured debts are like a car or property, where technically, the bank owns the asset until it’s paid in full. If you want to keep it, then you will need to continue making payments on those debts after bankruptcy. 

5. Complete a debtor education course

The next step is to complete the second debtor education course from an approved agency. You’ll find that most offer online courses or allow you to read a book and speak with a counselor.

It’s a very basic requirement, so you’ll want to take advantage of other sources to improve your financial know-how and get back on your feet faster. Seek out topics like managing your budget, saving money, and investing.   

6. Get your debt discharged

Finally, it’s done. Your debts are discharged. You now have an opportunity to start over. It will take time to rebuild your credit, but you can do it while building the financial strength you need. 

Rebuilding after bankruptcy

Filing for bankruptcy can stay on your credit report for some time — up to seven years (Chapter 13) and up to 10 years (Chapter 7). It’ll lower your credit score and you’ll pay higher interest rates as a result. Because of this, it’s important that you establish positive credit practices to rebuild your credit after a bankruptcy.