When to Declare Bankruptcy

If you have large debts that you can’t repay, are behind in your mortgage payments and in danger of foreclosure, are being harassed by bill collectors – or all of the above – declaring bankruptcy might be your answer.

Or it might not be.

Bankruptcy can, in some cases, reduce or eliminate your debts, save your home and keep those bill collectors at bay, but it also has serious consequences, including long-term damage to your credit score. That, in turn, can hamper your ability to borrow in the future, raise the rates you pay for insurance and even make it difficult to get a job.

Despite the negatives, more than 1 million Americans filed for bankruptcy during the 12-month period ending Sept. 30, 2013.

Bankruptcy cases are handled by federal courts, and federal law defines six different types. The two most common types used by individuals are Chapter 7 and Chapter 13, named after the sections of the federal bankruptcy code where they are described. Chapter 11 bankruptcy, which is often in the headlines, is primarily for businesses.

Chapter 7 bankruptcy, the type most individuals file, is also referred to as a straight bankruptcy or liquidation. A trustee appointed by the court can sell some of your property and use the proceeds to partially repay your creditors, after which your debts are considered discharged. Some types of property can be exempt from liquidation, subject to certain limits. Those include your car, your clothing and household goods, the tools of your trade, pensions, and a portion of any equity you have in your home. You should list the property you are claiming as exempt when you file for bankruptcy.

Chapter 13 bankruptcy, on the other hand, results in a court-approved plan for you to repay all or part of your debts over a period of three to five years. Some of your debts may also be discharged. Because it does not require liquidating your assets, a Chapter 13 bankruptcy can allow you to keep your home, as long as you continue to make the agreed-upon payments.

Certain types of debts generally can’t be discharged through bankruptcy. Those include child support, alimony, student loans and some tax obligations.

There are a number of legally required steps involved in filing for bankruptcy. Failing to complete them can result in the dismissal of your case.

Before filing for bankruptcy, individuals are required to complete a credit counseling session and obtain a certificate to file with their bankruptcy petition. The counselor should review your personal situation, offer advice on budgeting and debt management, and discuss alternatives to bankruptcy. You can find the names of government-approved credit counseling agencies in your area by calling the federal bankruptcy court closest to you or by visiting its website.

Filing for bankruptcy involves submitting a bankruptcy petition and financial statements showing your income, debts and assets. You will also be required to submit a means test form, which determines whether your income is low enough for you to qualify for Chapter 7. If it isn’t, you will have to file for Chapter 13 bankruptcy instead. You will also need to pay a filing fee, though it is sometimes waived if you can prove you can’t afford it.

You can obtain the forms you need from the bankruptcy court. If you engage the services of a bankruptcy lawyer, which is usually a good idea, he or she should also be able to provide them.

Once you have filed, the bankruptcy trustee assigned to your case will arrange for a meeting of creditors, also known as a 341 meeting for the section of the bankruptcy code where it is mandated. This is an opportunity for the people or businesses that you owe money to ask questions about your financial situation and your plans, if any, to repay them.

Your case will be decided by a bankruptcy judge, based on the information you have supplied. If the court determines that you have attempted to hide assets or committed other fraud, you may not only lose your case but also face criminal prosecution. Unless your case is very complex, you generally won’t have to appear in court before the judge.

After you have filed for bankruptcy – but before your debts can be discharged – you must take a debtor education course, which will provide advice on budgeting and money management. Again, you will need to obtain a certificate showing that you have participated. You can obtain a list of approved debtor education providers from the bankruptcy court or from the Justice Department.

Assuming the court decides in your favor, your debts will be discharged, in the case of Chapter 7. In Chapter 13, a repayment plan will be approved. Having a debt discharged means that the creditor can no longer attempt to collect it from you.

Both types of individual bankruptcy have some negative consequences. A Chapter 7 bankruptcy will remain on your credit record for ten years, while a Chapter 13 bankruptcy will generally remain for seven years.

According to Experian, one of the three major national credit bureaus, “Declaring bankruptcy has the greatest single impact on credit scores.” It may also make you appear to be a poor risk to companies that request your report, including other lenders, insurance companies and potential employers.

Note, too, that there are limits on how often you can have your debts discharged through bankruptcy. For example, if you have had debts discharged through a Chapter 7 bankruptcy, you must wait eight years before you can do so again.

It depends on who is filing. Unlike corporations and partnerships, individuals can file for bankruptcy without an attorney. It's called filing the case "pro se." But because filing for bankruptcy is complex, and must be done correctly to succeed, it's unwise to proceed without the help of an attorney experienced in bankruptcy proceedings.

Bankruptcy is sometimes the best way to get out from under crushing financial burdens, but it is not the only way. There are alternatives that can sometimes reduce your debt obligations without the messy consequences of bankruptcy.

Negotiating with your creditors, without involving the courts, can sometimes work to the benefit of both sides. Rather than risk receiving nothing, a creditor might agree to a repayment schedule that reduces your debt or spreads your payments over a longer period of time.

If you are unable to make your mortgage payments, the Federal Housing Finance Agency recommends calling your mortgage servicer to find out whether you qualify for mortgage modifications such as the Home Affordable Modification Program (HAMP), Home Affordable Foreclosure Alternatives (HAFA) or other help. However, beware of unsolicited offers from companies claiming that they can keep your home out of foreclosure. They may be nothing more than scam artists.

If you owe money to the IRS, you may be eligible for an “offer in compromise,” allowing you to settle with the agency for an amount less than you owe. In some instances, the IRS also offers monthly payment plans for taxpayers who can’t pay their tax obligations all at once.

Bankruptcy law exists to help people who have taken on an unmanageable amount of debt, often as a result of large medical bills or other unexpected expenses, to make a fresh start. But it isn’t a simple process and doesn’t always lead to a happy ending. So before taking that very serious step, be sure to explore all your alternatives.