Pros and Cons of Filing for Bankruptcy
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In the olden days (16th century, to be specific), filing for bankruptcy meant going to debtors’ prison, or in some cases, the gallows. But modern bankruptcy laws don't look to punish debtors. Instead, they're meant to be a reorganization of your finances in a manner that's beneficial for both debtors and creditors.
If you're knee-deep in debt, a Chapter 7 or a Chapter 13 bankruptcy may be your only option for debt relief. But beware: bankruptcy doesn't make all of your debts disappear. It should be seen as a second shot so you can avoid the decisions you made leading up to the bankruptcy filing, and work to rebuild your finances and start anew.
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Types of Bankruptcy
While Chapter 7 and Chapter 13 are both types of bankruptcies, the fine print reads slightly differently. Here are the differences.
What is Chapter 7 bankruptcy?
A Chapter 7 bankruptcy is also known as a liquidation because some of your assets are sold off by the bankruptcy trustee to pay off your creditors. Exempt assets include your home and work-related items deemed to be essential. Chapter 7 is also the most common type of filing in the U.S. For example, more than 55% of all bankruptcies filed between August 29 and September 4, 2022, were Chapter 7, according to the American Bankruptcy Institute. This bankruptcy filing involves unsecured debt, so types of debt like your credit cards, personal loans, and medical debt can be discharged. However, secured debts, alimony, child support, and student loans are not discharged. Overall, the process can last for up to six months.
What is Chapter 13 bankruptcy?
If you have a consistent income stream but are behind on debts, the bankruptcy court is unlikely to allow a Chapter 7 bankruptcy. And that's what a Chapter 13 filing is — a rehabilitation of your debts and assets. You'll be put on a program to pay back what you owe. The timeline? Three to five years, with a court-appointed trustee overseeing your payments. To become eligible for this filing, you must have a steady source of income and be current on your taxes.
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Pros and cons of filing for bankruptcy
Pros | Cons |
Unsecured debts, like credit cards and personal loans, are dischaged | Secured debts, child support, alimony and student loans are nondischargeable debts |
A bankruptcy filing gives you a second chance to start fresh | Bankruptcy stays on your credit report for 10 years |
Debt collectors and other creditors cannot hound you for payments | A bankruptcy filing costs more than $600 in addition to attorney fees |
Efforts to foreclose on your property stop after you file for bankruptcy | You'll remain in a court-mandated program for months or years |
Assets deemed essential are exempt, so you don't lose all of your assets | Rebuilding credit post bankruptcy is a long road |
Pros of filing for bankruptcy
Debt relief
That's why people file for bankruptcy, right? A bankruptcy filing — especially Chapter 7 — discharges your unsecured debt. So, credit card debt, any personal loans you took but have failed to make payments on, and medical bills you've accrued over the years, will get wiped out when you file for Chapter 7. In a Chapter 13 filing, however, you'll still have to pay some of what you owe. Still, overall you'll pay less money than you owe.
A fresh start
Not enough attention is given to this aspect. A bankruptcy filing is a second chance of sorts, one that allows you to start anew. Once you've completed the court-mandated program under either filing, you can begin to rebuild your credit. Will it be tough? Yes, but it's not impossible. But perhaps the best part about a bankruptcy filing is the lesson you learn. It puts you on the front lines of what can happen if you take on more debt than you can chew and lose control of your finances. Armed with first-hand experience, you're unlikely to repeat the same mistakes that got you in trouble.
Stops foreclosures
If you took out a loan, and the lender is now looking to foreclose on your property to recoup some of its costs, a Chapter 13 filing will stop them in their tracks. As noted, Chapter 13 is a reorganization of your finances, and as such, a plan will be developed depending on your financial situation. The goal of this plan would be to bring you back to being current on your mortgage payments, including past due payments.
Say goodbye to debt collectors
When you file a bankruptcy, debt collectors and other creditors cannot contact you about any unpaid debts until the bankruptcy case
closes. That means you don't have to worry about any phone calls at work or home or even threats of a lawsuit or wage garnishment ... because, let's be honest, collection agencies can really stoop low in their quest to get you to pay even if it's just a portion of what you owe in total. But this automatic stay on creditors allows you to shore up your finances before debt collection agencies can begin hounding you again.
Related: How to Pay Off Debt in Collections
You can keep some assets
Even in a Chapter 7 filing, where asset liquidation isn't off the table, you get to keep some of your assets. For example, if you need a car to get to work each day and the vehicle's value is below a certain number, you just may be able to keep it. Ultimately, however, it depends on the state you live in. And if your vehicle is above a certain value, it may be sold, but you'll receive cash above the threshold. Retirement accounts and unemployment benefits can also be exempt from bankruptcy.
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Cons of filing for bankruptcy
The cost
Wait ... it costs money to file for bankruptcy? Depending on your state of residence and the type of bankruptcy filing you're looking to make, you can expect to pay $1,000 to $6,000 in attorney fees. For the bankruptcy filing itself, the cost can be upward of $600. However, you may be eligible for legal aid under the circumstances. In any case, you should consult with a bankruptcy lawyer to better understand the costs associated with declaring bankruptcy.
Not all debts are discharged
As noted, bankruptcy isn't a magic wand that makes every debt disappear. For one, any secured debt like a home equity loan wouldn't be discharged. This means if you took out a loan against your home and failed to make payments, lenders might seize the property and sell it to compensate for their costs. Bankruptcy also doesn't discharge federal student loans, except if you have a severe medical condition. In addition, tax debt, alimony, and child support are exemptions from a bankruptcy filing.
It's a slow process
The court-ordered bankruptcy process can last for years. Filing bankruptcy, Chapter 13 for example, may see you in the repayment plan for three to five years. And a Chapter 7 filing lasts from four to six months. In both cases, most of your earnings will be directed towards debt repayment. While that's good, you may have to make less-than-ideal adjustments to your lifestyle to account for income going to creditors and not in your pocket.
A black mark on your credit report
Bankruptcy filings remain on your credit report for 10 years. Of course, as more time passes, it slowly begins to stop having the same influence as your first few years after the filing, for example. Still, for the duration of its stay on your report, a bankruptcy filing may give potential creditors pause because it tells them you're not good with money and thus may be a bad investment from their perspective.
Rebuilding credit
A bankruptcy filing means you're back to square one in terms of finances, providing an opportunity for you to rebuild your credit. Yes, it will be tough, but it's not out outside the realm of possibility. By following a few simple steps, you can demonstrate to future creditors that you're a responsible borrower, which will help you secure favorable interest rates.
Here are a few steps you can follow:
- Pay your bills on time: A bankruptcy filing should make this crystal clear, but paying your bills on time and in full may just help you stave off future bankruptcies or other events that may result in financial ruin.
- Keep credit utilization low: Don't max out your cards! Experts recommend that you spend only 30% of your total credit limit. Think of it this way: treat your credit card as a debit card.
- Avoid taking on more debt: This should be a no-brainer, but don't go about taking out more loans and signing up for unsecured credit cards. New credit doesn't help if you're struggling to repay existing debt.
- Get a secured credit card: To build credit following a bankruptcy, you could sign up for a secured credit card. You will have to deposit money into an escrow account, which will become the collateral for the balance on the card.
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The bottom line
Bankruptcy is an option of last resort to get out of debt. Before deciding, you should consider other options like debt settlement, debt consolidation, and enrolling in a debt management plan. While these methods wouldn't likely discharge any of your debts, they wouldn't hurt your credit score either, and thus chances of securing credit in the future would remain good.
Still, you shouldn't see bankruptcy as a punishment for your bad decisions; its intended purpose is to help you get back on your feet with a clean slate. Are there consequences? Of course, and that's why you should not take this decision lightly. If you're feeling overwhelmed by debt, you can also talk to a credit counseling agency. But if you think bankruptcy is the only way out, you should discuss the topic with a bankruptcy attorney and weigh your options.
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Writer
Jasir Jawaid is Joy Wallet's Assistant Editor. He has more than 13 years of experience as a journalist covering Wall Street, equities, financial policy and regulation, and cryptocurrency and blockchain.
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