While the United States economy seems to be bouncing back from the recession of the early 2000s, many people are still saddled with debt that may be impossible to eliminate. This overabundance of debt can lead people to consider filing for bankruptcy as a last resort when debt consolidation, mortgage restructuring or selling personal property aren’t enough to help them out of a financial hole.
Although it is often thought of as a sign of failure or an admittance of defeat, the truth is that bankruptcy gives many people fresh starts for new financial futures. This guide is designed to give people considering bankruptcy enough information to make the best financial decision for them. I cover the different types of bankruptcy they can file, the positive and negative aspects of filing for bankruptcy and the steps involved in filing for bankruptcy.
Methodology: To prepare this article I read and consulted over 38 print and online articles and two e-books about bankruptcy and consumer debt. I also read The Fragile Middle Class: Americans in Debt (2001) by Teresa A. Sullivan and Elizabeth Warren, which many economists consider one of the most influential books about debt written in the last decade. I also spoke with Jen Lee of Jen Lee Law in California. Lee is a debt and credit strategy attorney who has helped many people file for bankruptcy.
Who files for bankruptcy and why?
It is commonly thought that people who file for bankruptcy are reckless spenders and poor budgeters, but recent data shows this is not necessarily the case. According to Dan Mangan at CNBC, the leading cause of bankruptcy in 2013 was unexpected medical expenses for people with low income. This pattern has only increased in the following years and is part of a larger trend of an increase in personal bankruptcy filings from 1980-2005.
In her experience, Jen Lee has helped clients seeking bankruptcy advice for all types of reasons. “The most common I see are people with failed businesses. I also see a lot of people filing because of ‘lifestyle creep.’ People who have lost high-paying jobs but never change their standard of living often wind up in debt.” Other causes are divorce or separation, student debt, natural disaster damage, job loss and other unexpected expenses.
Personal bankruptcy filings have now far outpaced business bankruptcy filings. In fact, recent information states that 30 years ago, businesses accounted for 13 percent of bankruptcy filings. Now, only about three percent of bankruptcy filings come from businesses.
Recent data also suggests that about 52 percent of filers were male and 48 percent were females. Married people made up 64 percent of filings. Thirty-six percent of filers had at least a high school education, and 60 percent of filers make under $30,000 a year.
More recent filings remain fairly consistent with this data. Data from the United States Courts found at uscourts.gov shows that both business and nonbusiness filings were lower in 2016 than in 2012.
Types of bankruptcy
Should you decide to file for bankruptcy, there are two types of personal bankruptcy options: Chapter 7 and Chapter 13. There is also Chapter 11 bankruptcy for reorganizing a partnership or corporation, but because this is a guide for personal finances, I will focus on Chapters 7 and 13. Their differences are as follows:
Chapter 7 bankruptcy
Chapter 7, also known as “liquidation bankruptcy,” is usually what people think of when someone mentions bankruptcy. Under Chapter 7, the trustee sells all of the debtor’s nonexempt property in order to wipe out almost all of the debtor’s financial obligations. Here is what happens when you file chapter 7 bankruptcy:
- No repayment: The entire process takes from 3-6 months, after which your debt is cleared
- Property liquidation: Liquidate unprotected assets to pay debts
- Income status requirements for filing: Debtor’s income must fall below or be equal to that state’s median income, or debtors can submit a 'means test' which examines their financial situation to see if they qualify for Chapter 7
- Debt limits: There is no debt minimum or maximum for filing Chapter 7 bankruptcy
Tip: It is important to note that even under Chapter 7, some debts must still be paid. Child support, tax debt (unless debtor meets certain criteria to discharge federal tax debt), student loans (unless a bankruptcy court determines that undue hardship exists) and debt that resulted from fraudulent dealings will remain despite filing for bankruptcy.
Chapter 13 bankruptcy
Only debtors with dependable income can apply for Chapter 13 bankruptcy. Under Chapter 13, the debtor creates a plan to repay their creditors over a period of three to five years. Debtors do not have to liquidate their assets to repay their creditors, but any additional income after basic needs are met must go to the creditors. Here is what happens when you file chapter 13 bankruptcy:
- Time to repayment: Your debts will be repaid within 3-5 years
- Property liquidation: Keep property as long as debtor can stick to the proposed repayment plan
- Income status required for filing: Debtor must have steady income that fits with the proposed repayment plan
- Debt limits: There is no minimum, but as of April 1, 2016, the filer’s secured debt cannot exceed $1,184,200 and unsecured debt cannot exceed $394,725
Chapter 7 vs. Chapter 13 bankruptcy
Part of what makes filing for bankruptcy such a personal decision are the external factors beyond just the financial considerations, so it is not a decision to make without careful consideration. "I always recommend a debt strategy counseling session when someone is considering bankruptcy," Lee says. "I would say that only about 40 percent of my clients end up filing for bankruptcy."
Pros and cons of filing for bankruptcy
Bankruptcy can take a mental toll on an individual, often leading to a sense of failure. But at the same time, bankruptcy can eliminate stress from bill collectors and allow you to start rebuilding your credit sooner. The following list of pros and cons is designed to help you make sure you’re aware of the potential consequences, good and bad, that come with filing for bankruptcy.
Benefits of filing for bankruptcy
- Wipe away debt: The most apparent benefit is the peace of mind that comes with debt elimination. If your path to bankruptcy involved irresponsible spending, filing can give you a chance to revisit the steps that led to bankruptcy, allowing you the opportunity to plan more carefully for your future.
- Stops bill collector calls: When you file for bankruptcy, it becomes illegal for bill collectors to solicit payments from you. That extra stress caused by talking to or avoiding bill collectors can end when bankruptcy prevents them from calling you.
- Start rebuilding credit: A successful filing can give you the feeling of having a clean slate to start rebuilding your credit. Rebuilding credit is hard work, but bankruptcy can give you the chance to start over.
- Gets rid of credit cards: If you are prone to frivolous spending, eliminating credit cards may give you some relief. Losing credit cards can also give you the chance to start developing healthier spending habits.
- Avoid prolonging filing: One problem people who file for bankruptcy have is that they attempt to avoid bankruptcy by draining valuable resources. If bankruptcy is inevitable, you should consider the costs of putting it on hold. Using social security, retirement funds or any other protected assets unnecessarily drains finances to pay debts that would otherwise be wiped out with bankruptcy.
Disadvantages of filing for bankruptcy
- Credit and loan prospects: Part of rebuilding credit after bankruptcy starts with a clean slate. This means that, if your credit was in good standing before you filed for bankruptcy, your credit will drop. Your current credit cards disappear, and applying to any major loan or mortgage will not be an option for at least two years because of increased interest rates.
- New lending problems: While you rebuild your credit, you can apply for credit cards to start rebuilding credit, and after a few years, you can even apply for loans. However, if poor spending habits landed you in debt, be on the lookout for credit lenders who target recent filers and offer credit cards or loans with high interest rates.
- Public record of your filing: Your bankruptcy filing will also be a matter of public record, meaning that anyone can request your filings.
- Filing and attorney costs: Filing for bankruptcy isn’t free. A standard fee for filing is $335 for Chapter 7 and $310 for Chapter 13. This does not include attorney fees, should you decide to hire an attorney to help with your case. You will also need to pay for the required credit counseling.
- Mental and physical health problems: Many people who file for bankruptcy admit that it takes a toll on their mental and physical health. According to a study from Northwestern University, financial debt “is associated with higher perceived stress and depress, worse self-reported general health, and higher diastolic blood pressure.” Some have described feelings of failure and inadequacy after filing for bankruptcy, even in cases that resulted from surprise medical expenses or otherwise unavoidable events. Filing for bankruptcy can worsen these symptoms. If you are suffering from these symptoms, reaching out a financial therapist may be a good option before or after filing for bankruptcy.
After evaluating your options, you should have an idea if bankruptcy is your best course of action. If it is, your first step is to create a financial inventory. This document is an earnest account of your debts, expenses and property that must be complete to the best of your knowledge.
The first item to list is your debts from credit cards, student loans or any other outstanding balances. These should include your most recent balances, creditors, interest rates, payments and any other information about your loans. Have at least six months of information about outstanding debts just to be sure.
- Monthly living expenses
Next you should outline your monthly living expenses with at least six months of evidence to establish regularity. These include rent, utilities, food, clothing, medical fees, transportation, child support and any other monthly expenditures. For expenses that vary month-to-month, you can take the average based on your last year of expenses.
You should also include any income received over the last six months, excluding Social Security. This includes work wages, unemployment compensation, investment dividends, side income and financial contributions from spouses or other family members.
- Property and assets
Lastly, list any property and assets that have particular value: vehicles, real estate, art, furniture, clothing, valuable possessions. Some personal possessions are exempt, but exactly what constitutes exempt property may vary from state to state. If you’re unsure, it’s best to make your inventory comprehensive and go over it with your attorney or trustee handling your case.
Steps to filing for bankruptcy
After you make your financial inventory, you can start filing for bankruptcy. The actual filing process is long and complicated, but with enough foreknowledge, it can be made less difficult. Below are the five steps for filing Chapter 7 and Chapter 13 bankruptcy.
- Find a bankruptcy lawyer (optional)
You are not required to have a bankruptcy lawyer, but many people do. Lee always suggests getting a lawyer because bankruptcy is such a complicated process. She explains, "Bankruptcy is federal law across all states, but each court can have its own rules. The actual procedure varies from state to state." The more complicated your case is, the more likely you would benefit from hiring a lawyer. Attorney fees for Chapter 7 can range from $500-$3,500 depending on the case’s complexity, and fees for Chapter 13 fall typically between $2,500 and $6,000.
- Meet with a credit counselor
After creating an extensive and comprehensive financial inventory, you will go through credit counseling from an approved agency. You will need to pay for these services out-of-pocket which cost anywhere from $14.95-$100 per session. You need to provide proof of this counseling to file for bankruptcy, or your petition will be dismissed outright.
- File for bankruptcy
After you have undergone your financial counseling session, you are ready to file for bankruptcy. At this step, you will take a complete financial inventory that includes all your debts and assets. If you have hired an attorney, they will help you with this process and file for you. Ove your petition is filed, an automatic stay on all creditors and collectors goes into effect. This automatic stay halts further requests for collection and any legal actions creditors can take against you to pay for the debts you have incurred.
- Meet with your creditors
Once your filed petition is accepted, your creditors will be notified. You will then be appointed a trustee, a government employee who oversees your particular case. Your trustee will set up a meeting with your creditors, which usually takes place 3-6 weeks later. At this meeting, your trustee will ask questions about your debts, and you will be sworn to answer them honestly. Your trustee will then lay out the specific consequences of declaring bankruptcy at this meeting.
- Proceed with your filing
Your creditors have 60 to 90 days after the meeting to submit any objections that must be addressed before your filing can continue. If there are no objections, you can proceed with your filing. For Chapter 7, this means you will start liquidating your assets to repay your creditors. For Chapter 13, you will have a confirmation hearing within 45 days of the creditor meeting to confirm your payment plan. After these steps for either filing, the judge will issue a discharge order to your creditors to halt any further requests for collection.
- Complete a financial management course
Both Chapter 7 and Chapter 13 filings require you to complete a post-bankruptcy financial management course. This takes place 45 days after your creditors’ meeting for Chapter 7, and for Chapter 13, this session takes place the day before you make your final payment. You can take this course online, and it must be completed before your debts can be completely wiped away.
Bottom line: Ultimately, deciding whether or not to file for bankruptcy requires an honest assessment of your financial situation. Bankruptcy is a tedious process that can be emotionally and mentally draining, but you could easily make the same statements about living with debt. Lee explains, “I often tell my clients that bankruptcy is not the end. People can rebuild their credit a lot faster than they realize.” Bankruptcy is not an admittance of failure, nor is it a decision to make lightly. It is, however, a chance to restructure your finances and start with a clean slate.