Declaring bankruptcy is a big choice that can frankly be extremely scary. But you might be surprised to learn that the cons of bankruptcy are often outweighed by the pros. Personal bankruptcy can give you the clean break you need from debt, so you can start over. It’s often the best way to turn the page quickly on debt problems.
The Pros of Bankruptcy
There are some definite upsides to filing for personal bankruptcy, whether you file Chapter 7 or Chapter 13.
When you file for bankruptcy, it initiates an automatic stay. This means that creditors, lenders, and (best of all) debt collectors can’t contact you. They can’t attempt to get payment or call to harass you once you file. If they do, you can fight back and potentially be compensated.
The automatic stay also can delay foreclosure and repossession actions. As long as the automatic stay is in place while you go through the filing process, lenders can’t move to take your home or other property.
Bankruptcy won’t strip the clothes off your back. And while the courts may potentially liquidate assets during Chapter 7, even your home and car may be exempt from liquidation. So, even with a Chapter 7 filing, you could likely keep more assets that you might expect.
In the end, you won’t be burdened by all the debts you need to repay. You won’t have that weight on your shoulders of impending financial doom. Even if you have debts that are not discharged (more on this below), you won’t be obligated to repay the lion’s share of what you owe.
The pros of Chapter 7
“Chapter 7 bankruptcy is often the least expensive and fastest way out of debt,” Steve Rhode explains. “And it can help preserve retirement savings when you need it most.”
Essentially, Chapter 7 gives you a way to stop hemorrhaging money on debt payments that may not ever help you catch up. This frees up the money you were throwing away, so you can start saving for retirement. That’s crucial.
“If a 25-year-old debtor decided to enter into a credit counseling or debt settlement program, they would repay their debt. But that plan would cost them $23,231.12 in retirement funds that would be worth $1,247,526.55 when they eventually retired.”
This means that delaying your bankruptcy filing and trying to struggle out of debt using other means could hurt you in the long run. You might be better off filing for Chapter 7 so you can actually move forward instead of just continuing to treat water.
The pros of Chapter 13
Although Chapter 13 can take up to a few years to complete, there can still be advantages to filing. This is especially true if your creditors and collectors aren’t willing to play ball in debt settlement.
With Chapter 13 bankruptcy, the court trustee sets a repayment plan that pays back a portion of what you owe to each creditor. The process has a lot of similarities to a debt settlement program. Although ideally, you should prefer to keep settlement negotiations in your control and not give the final say to the courts, that’s only true if the people you owe are willing to negotiate.
In some cases, collectors may be too greedy to make settlement a viable option. For example, some collectors may try to jack up the amount you owe by applying interest charges. So, in this case, you might be better off leaving it to the courts. The court would decide if the extra charges fall in line with the terms of the original agreement. If not, they’d tell the collector to take off the extra charges.
The pros of Chapter 7 vs Chapter 13
Unless you have assets that have enough value that you wouldn’t qualify for the exemptions in your state, Chapter 7 is usually preferable to Chapter 13. It’s faster, easier and gives you the clean break you want. You could be enjoying final discharge this year, instead of a few years down the road.
And Steve says that the majority of people who file Chapter 7 rarely lose any assets at all. They either don’t have assets to liquidate, or their assets fall below the value that qualifies for exemptions in their state.
That being said, not everyone will qualify for Chapter 7. You must go through a means test when you file for bankruptcy. This compares your income to the median poverty income level in your state. If your income is too high, you may not get approved for a Chapter 7 filing. In this case, you’d be forced to file Chapter 13 instead.
If you need a professional opinion on whether it’s the right time to file, talk to a certified credit counselor for a free debt and budget evaluation, so you can weigh your options.
The Cons of Bankruptcy… and Why Many Aren’t as Bad as They First Appear
Even though bankruptcy can get you moving in a positive direction, that doesn’t mean it’s not without its downsides. However, our expert argues that many of those downsides are not as bad as they first appear.
Bankruptcy Downside #1: Your credit score will take a hit
Filing for bankruptcy creates a negative remark on your credit report. For Chapter 13, the negative item sticks around for 7 years from the date of filing. For Chapter 7, that extends to 10 years from the date of filing.
But this doesn’t mean that you will be forced to put your financial life on hold for a decade. In fact, you’ll recover much sooner than you expect. The “weight” of negative credit report items on your credit score decreases over time. So, the further you get away from a negative item you incurred, the less impact it has. And past negative items can be offset with positive actions moving forward. So, you can take steps to repair the damage and rebuild your credit.
Rhode also says the credit damage caused by bankruptcy is many times less than what consumers facing financial hardship incur if they don’t file. The evidence comes from an empirical data study by the Federal Reserve of New York in 2015. Essentially, if you try to muddle along and solve your problems on your own, you end up taking more credit score damage than you would have if you just bite the bullet and file.
Bankruptcy Downside #2: Not all debts may be discharged
There are certain debts that almost never get discharged, such as back child support or alimony. Tax debt is also not easily discharged, although it depends on the type of tax debt and your situation.
There’s also a common misconception that student loan debt can’t be discharged, even if it’s private. But our expert disagrees.
“Some federal student loans and many more private student loans can be discharged through bankruptcy,” Rhode says. “But many people don’t try because they buy into the myth. In truth, large parts of private student loans are not protected in bankruptcy, because trade or vocational programs were not Title IV qualified.”
The reason the myth exists is that the federal government did put in some protections for student lenders during consumer bankruptcy filings. The idea was that the government didn’t want people running up student debt that they had no intention to repay. The protections extended, not only to federal loans but also private loans as long as the education provided was Title IV qualified.
But this leaves a big loophole for borrowers that lenders would prefer that people didn’t know. Namely, there’s no harm in trying to get your student loan debt discharged. Even if the education was Title IV qualified, discharge is still possible in cases of extreme financial hardship. So, it’s worth it to at least ask for discharge.
Bankruptcy Downside #3: New financing may be a challenge
The common conception with bankruptcy is that you’ll become a credit pariah. You’ll be placed on a blacklist and traditional lenders will steer clear. But most of this fear is rooted in myth.
There is no such thing as a credit blacklist.
Although it may be tough to qualify for traditional prime loans and credit cards, there are other lending alternatives.
In other words, there are ways to get by as you rebuild credit and work to recover good credit. You can still buy a car and can even get yourself mortgage-ready in a short amount of time. And if you need credit cards, you can use secured credit cards if you can’t qualify for unsecured cards.
Rhode also explains that getting credit after you file often easier if you file for Chapter 7. “Chapter 7 filers have a greater opportunity to acquire unsecured credit from new lenders than Chapter 13 filers do. The rebound in new credit cards occurred more slowly for Chapter 13 filers, possibly because they were using a portion of their income to pay down old debts and because they can file for bankruptcy again more quickly than Chapter 7 filers can.”
Bankruptcy Downside #4: Cosigners are not protected
Cosigners and guarantors aren’t protected from collection on debts that you discharge through personal bankruptcy. So, you can get off the hook, but a loved one may get harassed over the remaining balance on a discharged debt unless you pay it off. This isn’t guaranteed to happen, but it’s definitely something to keep in mind.
Just make sure to talk to anyone that cosigned a loan with you before you file. Let me them know that you plan to file, so you can decide together how to handle the situation. Again, it’s not guaranteed that the lender or collector will pursue collection with them after a bankruptcy discharge, but it is a possibility.
The cons of Chapter 7 vs Chapter 13
If you’re choosing to file for bankruptcy, Steve Rhode recommends that you should always try for Chapter 7 first. The perceived downside of Chapter 7 is that it liquidates assets to repay your debt. That can make it seem like you’re about to lose everything. But Rhode says that’s usually not the case.
“A very, very small minority of Chapter 7 bankruptcy filers ever have to liquidate any asset,” Rhode says. By definition, Chapter 7 bankruptcy does liquidate assets to give you the fast, fresh start that it offers. But most people who file for Chapter 7 either don’t have any assets that can be liquidated OR their assets are low enough in value to qualify for exemption. So, the idea of losing everything in Chapter 7 is often really just a paper tiger.
By contrast, the con of Chapter 13 is real-time. When you file for bankruptcy, you’re doing it to get a clean break and fresh start. But that isn’t really what you get with Chapter 13. Instead, you end up on a repayment plan that can last anywhere from 3-5 years. This is roughly the same amount of time that a debt management program takes to complete. And it’s longer than the average debt settlement program, which takes 24-48 months, on average.