Financial ruin can occur for someone living paycheck-to-paycheck, just struggling to make ends meet.
It can also occur for doctors, lawyers and business owners — people who seem to exude financial savvy and success.
Bankruptcy, which allows overwhelming debt to be forgiven or restructured under the protection of a federal court, can happen for anyone.
Dan LaBert, executive director of the National Association of Consumer Bankruptcy Attorneys, said bankruptcy provides “the chance for a fresh start’’ and serves as a legitimate option, regardless of someone’s station in life.
But what happens when you file for bankruptcy? This page will explain the process, giving options for individuals and providing information to help the understanding of bankruptcy.
Personal Bankruptcy: Two Types
There are two main types of bankruptcy for individuals and another route that is generally used for businesses.
Some people refer to Chapter 7 bankruptcy as “liquidation bankruptcy’’ because it discharges most of your unsecured debt. That includes personal loans and credit cards.
It’s the quickest, simplest and most common type of bankruptcy.
How to Qualify
- You must pass a “means test’’ (which examines financial records, including income, expenses, secured and unsecured debt).
- You must qualify under income limits (it varies by state).
How it Works
- You might be forced to sell any non-exempt assets (although many assets can be retained).
- Generally, the Chapter 7 process can be completed in three to six months.
Chapter 13 bankruptcy is also known as “reorganization bankruptcy.’’ It sets up a repayment plan that allows you to pay back creditors over time. No property is required to be liquidated, but the process might take three to five years before it’s completed. For Chapter 13 bankruptcy, you must have regular income to make the required monthly payments.
How to Qualify and How it Works
Chapter 11 bankruptcy is somewhat similar to Chapter 13, but it’s typically reserved for businesses. Essentially, it’s a reorganization or restructuring of the company. It’s possible for businesses to file for Chapter 7 bankruptcy, but that means a liquidation of assets, so Chapter 11 is a more attractive option. That allows businesses to maintain their assets and continue operations, but they must devise a plan to pay off some of their debt or get it forgiven.
The Chapter 7 Bankruptcy Means Test
To qualify for Chapter 7 bankruptcy, you must pass a bankruptcy means test.
Here’s how it works.
First, determine your current monthly income. Add your gross income from the past six months and divide by six. In other words, if your gross income was $4,000 per month from January to April, but you were laid off and had no income in May or June, this is how to calculate your current monthly income:
$4,000 + $4,000 + $4,000 + $4,000 + $0 + $0 = $16,000
Next, divide by the six months.
$16,000 \ 6 = $2,666
After determining your current monthly income, see if it is above or below the median monthly income for your state. If it is below, you qualify for Chapter 7 bankruptcy. No further calculations are needed.
If Your Income Exceeds the Limit
What if your income is above your state’s median monthly figure? Then it’s time for another part of the means test.
It involves deducting reasonable and allowable expenses (such as food, housing and transportation) from your income. After making those deductions, if it is determined that you have reasonable income remaining to make your debt payments, you will not qualify for a Chapter 7 bankruptcy.
You still could pursue a Chapter 13 bankruptcy, while keeping your assets and working to pay off a portion of your debts with a system determined by the bankruptcy court.
Nearly 800,000 Americans filed for bankruptcy in 2016 (down from 1-million in 2013). Chapter 7 bankruptcies accounted for about 55% of the filings with Chapter 13 accounting for about 37%.
Which Debts are Discharged in Personal Bankruptcy?
Bankruptcy allows you to discharge debts in the following categories:
- credit cards
- auto loans
- medical bills
- utility bills
- personal loans
Which Debts Are Not Discharged in Bankruptcy?
The following debts are not forgiven in personal bankruptcy:
- tax debt (although some IRS debt could be eligible for a payment plan)
- child support
- student loans
If you have luxury item purchases or cash advances received immediately prior to the bankruptcy filing, creditors can challenge that, saying these were premeditated transactions, and have them excluded.
Another consideration: A bankruptcy discharge is personal and protects you. But it does not eliminate the debt itself. For example, if you had a co-signer on a home loan and you file for bankruptcy, the lender can still seek to collect the debt from the person who co-signed the loan. This is important to remember if you have family members or friends co-sign a loan, but are not going to file for bankruptcy.
Consequences of Bankruptcy
Though your finances may be in bad shape, filing for bankruptcy can still cost you a significant amount of money. Retaining a bankruptcy attorney could cost you several thousand dollars.
If you prepare and file your own bankruptcy case, the filing fees alone are substantial.
According to the National Bankruptcy Forum, the average cost of a Chapter 7 bankruptcy is $1,250.
Bankruptcy on Your Credit Report
Chapter 7 bankruptcies will remain on your credit report for 10 years. Chapter 13 bankruptcies remain on your credit report for seven years.
As part of any bankruptcy filing, there’s a required educational process.
Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, consumers must undergo bankruptcy counseling 180 days before filing. The counseling provides education about the process. After filing, consumers must complete an pre-discharge course (mandatory to have your debts discharged) about personal financial management. It’s designed to prevent additional and future financial difficulties. It will provide structure for managing your money, creating and maintaining a budget, and using credit appropriately.
Bankruptcy Pros and Cons
If you’re still debating whether to file for bankruptcy, it’s prudent to schedule a 30-minute no-obligation session with a credit counselor. You’ll get a neutral opinion on your financial situation and perhaps some clarity.
It’s always a good idea to consider the pros and cons.
- Eliminates or reduces debt for people in dire financial situations, perhaps due to illness or loss of a job.
- Temporarily prohibits creditors from foreclosing on a home or repossessing a car.
- Temporarily prevents wage garnishment, debt collectors’ harassment or disconnection of utilities.
- Allows consumer to get a “second chance” with their finances.
- Affects credit record for up to 10 years, creating problems in obtaining loans for cars, homes or loans.
- Becomes a public record that can be viewed by potential employers, insurance companies, banks and other lenders.
- You may not qualify for loans for several years, especially mortgage or home equity loans. And if you get loans, the interest rates will be much higher.
Judgment Proof is an option for individuals whose sources of income – Social Security, Disability, ERISA Pensions, Veteran’s Benefits, Worker’s Compensation, Public Assistance, Child Support and Alimony – are protected by law.
Those income sources might be protected, but they often don’t provide recipients with sufficient income to pay their unsecured debts.
Credit counselors from a nonprofit agency can explain your situation to creditors, while handling all communications and requesting that collection activity be halted.
If you qualify, this approach can avoid the costs, court involvement and embarrassment associated with bankruptcy.
Warning from the Experts
Millennials are at great risk for bankruptcy and that’s the impetus for an outreach program called CARE (Credit Abuse Resistance Education), founded by a group of bankruptcy professionals.
The volunteers (judges, attorneys and trustees, the people who handle the administration of bankruptcy cases) visit high schools and colleges to share personal experiences of people who have filed for bankruptcy protection.
According to Demos, a non-partisan, nonprofit New York-based research organization, America’s population of young adults have been in a consistent downward debt spiral.
Making ends meet continues to present significant challenges, according to the 2016 National Financial Capability Study (NFCS), released by the FINRA Investor Education Foundation.
The greatest concerns are found among young Americans (18-34 age group), where 22% reported taking a loan from their retirement account, 26% overdrew on their checking account and 29% were late with mortgage payments.
“It is troubling and it spells a difficult time for millennials,’’ said Gary Mottola, research director at FINRA Investor Education Foundation, and an author of the study. “These students came of age in an economy and job market that is weak at best, although better than it was. It’s very troubling to see them tapping into retirement and overdrawing their checking accounts. Their financial literacy levels are very, very low and you can see where all the forces make it a tough situation.’’
The reality is that a significant number of young people are finding themselves in deep debt before they hit their mid-30s. According to the Federal Reserve’s Survey of Consumer Finances, the average credit card debt for young adults (aged 25-34) increased 55% between 1992 and 2001 to $4,008. It zoomed to $5,848 in 2016 (an increase of 31% in 15 years).
Another troubling finding: Americans aged 25-34 have the second highest rate of bankruptcy, just after those aged 35 to 44.
So, the purpose of the CARE program is to target high-school and college students, catching them before they make the same mistakes of young bankrupt individuals. CARE officials said they have mostly seen young people go bankrupt because of credit abuse, not a catastrophic life event such as exorbitant medical expenses.
The organization’s website is at http://care4yourfuture.org/
If your income is too high for a Chapter 7 bankruptcy, there are other financial options available besides a Chapter 13 bankruptcy.
There are many nonprofit consumer credit counseling organizations that can negotiate more favorable terms with creditors, usually a very efficient strategy with credit-card companies. The repayment program will be managed properly and fees could be avoided.
Debt Management Plan — Entering a debt management plan can provide enough relief to allow you to eliminate debt over a 3-5 year period. Under debt management, credit counselors work with lenders to reduce interest rates, fees and penalties to an affordable level. In return, you promise to pay back the full principal over time in an efficiently managed manner.
The debt management plan provides an organized monthly payment plan. It provides an opportunity to handle the debt more efficiently than trying to sort it out yourself. By keeping the payments on track, it will be good for your credit score.
Some caveats: There is generally an enrollment and maintenance fee and the DMP is never a guaranteed option. Creditors have no obligation to participate.
Debt Consolidation Loan — This option combines all your debts into one manageable bill and pays them off with a single loan that has a reduced interest rate.
Debt consolidation companies are experienced at acquiring loans and finding the lowest monthly payment. With credit-card loans, the consolidated interest rate can be significantly less than what is being charged on each of your credit cards.
Look for a dependable and experienced debt consolidation company (with at least five years of experience). Also, be wary of consolidating several unsecured loans into one secure loan, meaning one backed by collateral like a home or car. If you can’t pay back the loan, collateral items are at stake and you could lose them.
Debt Settlement — It’s a lump-sum settlement payment with creditors, although this option is generally a consideration only for people with very poor credit. The goal is to pay significantly less than what you owe, sometimes only 50%, and retire the debt.
It’s important to determine — up front — whether the company negotiating the debt settlement is charging a percentage of the debt as its fee or has a flat-rate fee.
Be aware that debt settlement is damaging to your credit score. Lenders often will report the debt as “settled for less than agreed’’ or “settlement accepted’’ and the damage to your credit score lasts for seven years.
Is Bankruptcy Right for You?
Whether it’s bankruptcy or another debt-relief option, once completed, your financial situation will seem like a mess. Without debts, though, you can start on the road back. Setting up a budget and applying for a secured credit card are some preliminary steps to re-establishing credit.
You will likely need to change your spending habits. Regular credit counseling or help from a financial planner could be a smart approach. It’s also very important to pay all your bills on time and never use credit cards or loans as an extension of your income.
- It’s common sense time.
- Live within (or beneath) your means.
- Be thankful for what you can afford.
- The new financial goal: Never ending up in a bankruptcy situation again.