Rising unemployment and reduced income has driven more than one and half million
Americans to file for bankruptcy protection this year. And with Fed Chairman Ben Bernanke's prediction that it's going to take longer for the economy to recover than previously expected, we can expect even more bankruptcies next year.
People considering this drastic move need to know that in 2006 the bankruptcy laws changed making bankruptcy a less attractive alternative. Unfortunately, according to Smart Money magazine, it is the most responsible consumers who pay their mortgage on time and save for retirement that wind up losing the most in the bankruptcy process.
The American Bankruptcy Institute says nearly two thirds (65%) of those who filed for bankruptcy this year cited "income reduction as the reason, while 42% listed "job loss as a reason. Many chose both.
Steve Elias is a bankruptcy attorney in Lakeport, California and co-author of "How to File for Chapter 7 Bankruptcy. In an interview with Smart Money, Elias said that bankruptcy filers who have been conscientious borrowers and consumers will often have equity in their homes, possess cars that are partly or fully paid for, and hold savings accounts designed to provide for them in the future. But there's no credit for being responsible when it comes to bankruptcy court " and the more responsible a consumer has been, the more they have for a trustee to take and sell off to pay creditors.
Your FICO credit score will also take a huge hit. Someone with a magnificent credit score of 780 will drop 240 points if they file for bankruptcy. But if your score is only 680, it will only go down 150 points due to a bankruptcy.
Two kinds
In an earlier column I wrote on bankruptcies ("Is Bankruptcy Your Personal Bailout? ConsumerAffairs.com, October 25, 2008) I explained the two types of bankruptcies, Chapter 13 and Chapter 7, and how they worked.
A Chapter 13 bankruptcy is for someone who is trying to hold on to their assets and who also makes enough money to cover daily expenses and has something little left over to pay creditors a reduced amount. It works like this. A payment plan is set up through the court, but usually for less than the amount owed. Payments are made over a three-to-five year period, and must equal at least the amount of money creditors would have received if you filed for Chapter 7.
As for Chapter 7, it's for anyone who has no assets such as a home or car, and has just enough to possibly cover daily expenses, but nothing more for a payment plan. In Chapter 7, all non-exempt assets are sold and proceeds are given to creditors. Most debts are then forgiven.
In terms of what you can and can't keep in a bankruptcy often depends on where you live.
Homestead exemption
For example, Florida and Texas have what's known "homestead exemptions" which means your home is protected. Some states have rules governing occupancy and that you have to actually own the property. Other states only allow you to keep a home, provided you have a certain amount of equity invested in the property. There are a number of exemptions in each state that allow consumers to hold onto some assets.
One of them is a federal credit known as the "wild card option of up to about $12,000 per person, which is available in 16 states and Washington, D.C. and can be used to help you keep items like cars or jewelry. Some states have their own wild card options, but they're far less generous. There are also assets that bankruptcy trustees aren't interested in taking because they won't yield profits to pay creditors, such as a home or car that you owe more on than it's worth.
Key assets
There are five key assets that might be protected in bankruptcy.
1. The first is your home. But as I said, it all depends on where you live and the equity you have in your house. In Florida you can keep up to 160 acres outside of city limits and up to half an acre and a home in cities. Texans can protect up to 200 acres of rural property or up to 10 acres in the city. And in general, if a home is worth less than the mortgage balance, you can keep it as long as you stay current with the mortgage payments.
If you have equity in your home, most states offer an exemption, such as money from the bankruptcy trustee's sale of the home that stays with the homeowner. But over that amount, every penny of a sale is applied to outstanding debts and paying the trustee. In California, for example, the equity exemption is up to $175,000. Other states are far less generous: In Ohio, the state exemption for a home is only $45,600 if married or up to half that for singles. In Tennessee, the exemption is just $12,500 for singles and up to twice as much for couples.
2. Next, tax-exempt retirement funds such as 401(k)s and individual retirement accounts (IRAs), are out of reach from creditors. IRAs are protected up to about $1.17 million per person. Howard Ehrenberg, a bankruptcy attorney and member of the Chapter 7 Panel of Trustees for Central District of California, says bankruptcy trustees view these accounts skeptically and will flag suspicious actions like dumping cash and investments - which are usually not protected in full in bankruptcy - into retirement plans. If you get caught trying to protect assets in that way you risk losing some of that amount.
3. Whether you can keep your car varies from state to state as well. Usually, if you owe more than the car is worth you can generally keep it, as long as payments stay current. Free-and-clear car owners can keep a car if it's worth less than the state exemption, but drivers who have a car loan and some equity in their car can have their vehicle seized and sold, and recoup only their equity up to the exemption. Delaware and Nevada grant the most generous exemptions for cars, each up to around $15,000. In the 16 states that follow the federal exemptions, including Connecticut, New Jersey and Pennsylvania, the federal car exemption is just up to $3,450, but bankruptcy filers can also to dip into the federal "wild card of up to roughly $12,000 to keep the vehicle. Married couples who jointly own the car can claim a federal exemption of up to $30,900. One of the strictest states is Florida, where the exemption is capped at $1,000 and there's a wild card option of up to $2,000 per person, assuming the couple hasn't claimed a homestead exemption.
4. The fourth asset you can keep is a term life insurance policy. Whole-life insurance policies on the other hand are considered an investment vehicle. Depending on the state, there could be exemptions - Florida protects the entire policy, other states only protect a fraction. And in Ohio, life insurance policies remain intact when the beneficiary is a dependent; otherwise, there's no exemption, and the state's wild card is around $1,075 per person.
5. Finally, a college savings plan such as a 529 plan may be exempt but it depends on a number of factors. If a 529 plan is less than two years old, protection is limited to $5,000 and creditors can take what's been saved beyond that. It's the same with college savings plans known as a Coverdell account. After that two-year period, the plan is safe, as long as the person filing for bankruptcy is not the beneficiary or if the beneficiary is not the child or grandchild. For example, if the bankruptcy filer is the beneficiary, that money can be used to pay creditors.
