Should I file for bankruptcy?

What is bankruptcy?

Bankruptcy is a legal process designed to provide individuals and businesses with relief from overwhelming debt. Certain types of debts, such as credit card balances, medical bills and personal loans, can be discharged through bankruptcy. Additionally, bankruptcy can stop wage garnishments in many cases. However, not all debts can be discharged, including certain tax obligations and child support payments.

There are a number of reasons why you might seek bankruptcy. But Jen Lee, a bankruptcy attorney in the Bay Area of California, says the most common reason she sees is a failed business.

“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,” added Lee.

While bankruptcy can provide debt relief, it is not an easy solution. Filing for bankruptcy can have a significant impact on your credit score and financial situation for many years, making it difficult to get approved for a loan or mortgage.

» MORE: Debt settlement vs. bankruptcy

Types of bankruptcy

The three most common types of bankruptcy are Chapter 7, Chapter 11 and Chapter 13. Many people think that bankruptcy is a single action, but there are actually a few different ways an individual can file. The type you choose depends on how much you owe, who you are and your ability to pay some or all of your debts.

» MORE: What happens after an automatic stay is lifted?

Reasons for filing for bankruptcy

There are many different reasons why someone might seek protection from creditors through bankruptcy. While some people assume that being bankrupt means you have no money, the reality is much more complex and there is no minimum debt requirement to file.

Here are some of the most common reasons why a person or company files for bankruptcy.

• Medical debt: Sickness or injury can lead to massive medical bills, even if you have a solid health insurance policy. Additionally, a medical situation may limit your ability to earn income while you recover or take care of someone else.
• Divorce: Divorce can significantly affect your finances. Divorce attorneys can be expensive, and your share of joint debt can be overwhelming on one income or after accounting for spousal and child support.
• Job loss: Whether you're living paycheck to paycheck or comfortably on your current income, your own job loss or a spouse’s job loss can wreak havoc on your finances.
• Judgment against you: Getting sued is expensive when you factor in attorney bills, court costs and potential judgments against you or your business. Depending on the case, a judgment can exceed your insurance policy limits, net worth and ability to repay.
• Overbearing contract terms: Some contract terms are so one-sided that you need a bankruptcy judge to help negotiate and rightsize the terms to make them more affordable for you. While this approach is primarily used by business owners, it can be applicable to consumers as well. For example, your rent is much higher than market rates, or your loan interest rate is so high that it qualifies as usurious.
• Failed business: According to the online business resource Chamber of Commerce, nearly one in five small businesses fail in the first year, and 50% fail after five years. A business failure can leave you with substantial debt and no way to pay it back.

Filing for bankruptcy can carry a stigma, but it’s nothing to be ashamed of. In many cases, circumstances beyond your control can overwhelm your finances, and bankruptcy is the only reasonable path out.

» LEARN MORE: Personal loan after bankruptcy: how it works

When is bankruptcy the best option?

Bankruptcy should be pursued only after you have exhausted all other options and received financial counseling.

"I always recommend a debt strategy counseling session when someone is considering bankruptcy," Lee said. "I would say that only about 40% of my clients end up filing for bankruptcy."

Additionally, bankruptcy should be considered if it can save you from losing your home.

"Bankruptcy is a good option if you are expecting major events to occur due to your debt,” said Derek Jacques, a family law and bankruptcy attorney with The Mitten Law Firm. “Because bankruptcy puts a halt on collection actions, it also puts a hold on foreclosures, evictions and repossessions, at least for a time. Then you can use the exemption rules to help save your property from being seized.”

» MORE: Is a 401(k) protected from bankruptcy?

What are the consequences of filing for bankruptcy?

One of the biggest impacts filing for bankruptcy will have on you is a change in your credit score. It negatively affects your credit score and makes you less likely to be approved for financing for several years. Depending on your situation, you might also be required to liquidate certain assets to repay some of your debt. You may consider signing a reaffirmation agreement that sets certain assets outside the bankruptcy, like a car loan.

Another consequence of bankruptcy is that your co-signer, like a parent or spouse, may be responsible for debt that you can’t pay back. If you have a loan that someone co-signed, depending on the type of bankruptcy you file for, they may be required to pay and creditors will go after them.

Going through bankruptcy is not just financially draining; it is emotionally draining as well. Having bankruptcy listed on your file can be a red flag to landlords or employers. The impacts of bankruptcy will follow you around for years, making it difficult to see the light at the end of the tunnel.

» MORE: What is debt forgiveness?

Alternatives to filing for bankruptcy

Filing for bankruptcy isn't the only option if you’re having trouble repaying your debt. Before going down this path, consider these alternatives.

• Get a debt consolidation loan. A debt consolidation loan pays off your existing debt and consolidates it into a loan with one monthly payment. A debt consolidation loan can potentially lower the interest rate on your debt or extend the term to reduce your monthly payment amount. When deciding between debt consolidation and bankruptcy, know that consolidation loans focus on gradually paying down the balance owed and put you on a path to being debt-free at the end of the loan term.
• Negotiate with your creditors. Contact your creditors to negotiate your interest rate, the amount owed and repayment terms. They may be willing to renegotiate your terms so you can avoid filing for bankruptcy.
• Open a balance transfer credit card. If you can qualify, apply for a balance transfer credit card with a low interest rate. Many of these cards offer promotional interest rates as low as 0% for 12 to 21 months, which can help you pay down your balance faster.
• Borrow from friends and family. Your friends and family may be able to gift or lend you money to take care of your debts. But keep in mind that this could cause problems in your relationship if you’re unable to repay.
• Sell your assets. Consider selling unused or rarely used assets and putting the proceeds toward paying down your debts. Downgrading your car or moving to a lower-cost home can also free up extra cash.
• Increase your income. You can put more money toward your debt if you boost your income by getting a second job or starting a side hustle. You may benefit from switching companies, particularly in a strong job market.

» MORE: Debt settlement vs. debt consolidation

Bottom line

Deciding whether or not to file for bankruptcy requires an honest assessment of your financial situation. It is a tedious process that can be emotionally and mentally draining, but you could easily make the same statements about living with debt.

As Lee said: “I often tell my clients that bankruptcy is not the end. People can rebuild their credit a lot faster than they realize.”