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What Is the Downside of Filing for Bankruptcy?

Filing for bankruptcy may be a reasonable choice for individuals or businesses with overwhelming debt. However, the process does come with its disadvantages, which can affect your financial health. So knowing your options is important before taking this route.

Rachel Velez • March 9, 2022

According to the Administrative Office of the U.S. Courts, over half a million bankruptcies were filed in 2020. Many individuals and businesses file for bankruptcy in order to get relief from their difficult financial situations in regards to debt and money they owe to creditors. 

Although bankruptcy isn’t always the answer, it could provide immediate help to those who are struggling. What’s important to know is that there are various drawbacks to filing for bankruptcy, and many can affect your financial circumstances for several years. While filing for bankruptcy can alleviate financial burden, it isn’t the best course of action in every situation. 

Many consumers pursue bankruptcy without a full understanding of the implications or taking a deeper look at alternate options. As it may seem like the only choice upfront, be sure to carefully examine the repercussions of filing for bankruptcy and make sure they are outweighed by the benefits.

In This Article

  1. What Is Bankruptcy?
  2. What Happens When You File for Bankruptcy?
  3. Most Common Types of Bankruptcies
  4. Other Types of Bankruptcies
  5. Pros and Cons of Filing for Bankruptcy
  6. FAQs
  7. Final Thoughts

What Is Bankruptcy?

Bankruptcy is a legal proceeding that offers relief to individuals and businesses experiencing mass amounts of debt. This process is accessible for those who are struggling financially and are unable to pay their outstanding debts. Bankruptcy is a way for those facing hardships to obtain a fresh start with their finances. 

Typically the process of filing for bankruptcy involves credit counseling from a certified agency then working with an attorney to file the appropriate paperwork. Once your petition is filed, a court-appointed bankruptcy trustee will usually begin managing the process.

Federal courts take care of all bankruptcy cases, as the rules state in the U.S. bankruptcy code. Before the federal courts determine your eligibility, you’ll be required to answer questions from the trustee and creditors about your bankruptcy forms and finances.

Filing for bankruptcy gives people the opportunity to eliminate debt and start over; however, many people take on bankruptcy without understanding the downsides of the process. While it’s not a fit for every situation or circumstance, weighing the pros and cons, along with being fully aware of the process, is key to making an informed decision.

What Happens When You File for Bankruptcy?

Bankruptcy is generally considered a last resort for people who are in a lot of debt and aren’t able to pay their bills. Before filing for bankruptcy, there are alternatives that are worth exploring. Some are less costly than bankruptcy and likely to do less damage to your credit score. First, find out if your creditors are willing to negotiate, as some creditors will agree to accept reduced payments or lower your interest rate over a long period of time.

Before you file, you’ll be required to attend counseling with a credit counseling organization approved by the Department of Justice’s U.S. Trustee Program. The counselor will look at your personal financial situation, discuss the alternatives to bankruptcy, and help you figure out a plan. Typically, personal bankruptcy cases begin when an individual or a couple files a petition in bankruptcy court, either on their own or with the help of a lawyer. 

Once a bankruptcy case is filed with the courts, a bankruptcy judge will then review the case and determine if the debts should be discharged. Depending on the type of bankruptcy you file, your bankruptcy proceedings may be slightly different. While the goal is to get a discharge, relief is immediate. You’ll then work with a bankruptcy trustee who will deal with your creditors on your behalf moving forward.

Most Common Types of Bankruptcies

There are several different types of bankruptcies that individuals and businesses can file for when facing financial hardship. There are specific rules and limitations for each; therefore, it’s good to know your options to find the best fit for your financial circumstance if bankruptcy is the chosen route.

Chapter 7: Liquidation

Chapter 7 bankruptcy, also known as liquidation, lets individuals and businesses give up their assets and walk away from most debts. This type of bankruptcy is most common for individuals. A court-appointed trustee supervises your assets being taken to pay off creditors, while the remaining unsecured debts are typically erased. This excludes some types of debts such as student loans and taxes. You’re eligible for Chapter 7 bankruptcy if the court decides you don’t meet a certain income level or don’t have enough money to pay back your unresolved debts. 

Chapter 13: Repayment Plan

Chapter 13 bankruptcy is essentially a repayment plan where your debts are reorganized. A plan is created that allows individuals and businesses to work toward repaying their debts without selling any assets. This is done as the filer works to lower interest rates on existing debts, reduce the principal amounts, extend the repayment periods or terms for certain debts, or explore refinancing options. 

The bankruptcy court will approve a monthly payment plan for you to pay back a portion of your unsecured debt and all of your secured debt over a period of 3 to 5 years. The monthly payment amounts will depend on your income and the amount of debt you have. 

Other Types of Bankruptcies

Although Chapter 7 and 13 bankruptcies are generally more common, there are a few other types of bankruptcies available for specific entities, such as larger organizations and family farmers.

Chapter 9: Municipalities

Chapter 9 bankruptcy is another repayment plan that allows municipalities such as towns, cities, and school districts to reorganize and pay back debts, again, without selling their assets. 

Chapter 11: Large Reorganization

Chapter 11 bankruptcy is mostly used to reorganize the debt(s) of businesses or corporations. With this chapter, businesses come up with a plan for how they’ll continue to operate the company while paying off their debt. Both the court and the creditors must approve this plan, as it allows the filer to draft an arrangement to repay some debt while retaining assets.

Chapter 12: Family Farmers

Chapter 12 bankruptcy is a repayment plan for family farmers and fishermen that can be an opportunity to reorganize their debt without selling their assets or properties. While it’s similar to Chapter 13 bankruptcy, Chapter 12 is more flexible and has higher debt limits. Repayment usually stretches out over 3 years, but a court can also decide to extend the repayment period up to 5 years.

Pros and Cons of Filing for Bankruptcy

There are advantages and disadvantages to consider before you file for bankruptcy, and it’s important to know what those are before making a final decision. Keep in mind that the type of bankruptcy you file will affect these principles as well. 

Pros

  1. You can achieve a clean slate financially: If you find yourself in a hole with your finances and feel like you can’t pay off any of your debts, bankruptcy may be an opportunity for a fresh start. Bankruptcy can essentially let you start from scratch to rebuild your financial reputation and reestablish your credit.
  2. You’re granted an automatic stay: The instant you file, you’re protected under a provision in bankruptcy law called the automatic stay. Creditors can’t collect payment of your debts or take other legal actions against you until the bankruptcy is discharged or a repayment plan has been finalized. You avoid dealing with creditors and debt collectors blowing up your phone as you work to better your finances!
  3. Potentially consolidate or discharge debts: It’s likely that the most significant benefit of bankruptcy is consolidating your debts or writing them off completely. Bankruptcy can offer some relief by combining your debt into manageable payments, and sometimes, a lot of your debts can be wiped away altogether. Either way, it has the power to get rid of a lot of stress in just a few months. The filing you select will determine this, and your creditors will have to accept whatever payment is determined in your bankruptcy case. 

Cons

  1. Your credit score will drop: If keeping up with monthly payments has been a struggle for you, then it’s likely that your credit score has taken a hit, and a bankruptcy filing may cause additional harm to that number. Filing for bankruptcy will inevitably create a negative remark on your credit report. For example, a Chapter 7 bankruptcy stays on your report for 10 years from the date of filing, while a Chapter 13 sticks around on your file for 7 years. This will make it harder to apply for credit, which means you may have to hold off on major purchases for a while. Buying a house, returning to school, or even applying for a credit card will all become more difficult after you file. Keep in mind that while these impacts don’t last forever, they’re long-term.
  2. Your assets can be taken: Depending on which type of bankruptcy you qualify for, your income and the equity in your assets can be taken away from you. When you declare certain types of bankruptcies, these assets can be taken, or liquidated, and used to pay off your debts. Luxury items are the first to go, such as vacation homes, a second car, jewelry, and household furnishings. If you aren’t prepared to be separated from your personal possessions, bankruptcy might not be the best option for you. 
  3. Not all debts will be discharged: A big misconception when filing for bankruptcy is that all of your debt will be permanently erased or written off. While filing for bankruptcy may help wipe out unsecured debt like medical bills, personal loans, or credit card debt, not all debts are eligible to include in bankruptcy filings. You’ll still be responsible for things like alimony and child support, taxes, and student loans. Personal injury debts caused by intoxicated drivers are still fair game as well. So, even if you declare bankruptcy, you still may have to face outstanding debts, and depending on the debt you struggle with the most, bankruptcy may not be worth it at all.
  4. Bankruptcy can be costly: Bankruptcy does help relieve you of your debts, but it isn’t free to file. From filing the bankruptcy itself to attorney fees, you could be responsible for hundreds — even thousands — of dollars. Filing costs more than $300 for both Chapter 7 and 13, and, if you hire a bankruptcy attorney, you could also pay thousands of dollars in legal bills. And remember, if you file for Chapter 13, you’ll have a repayment plan set up, so you’re still paying for your debt long after you declare bankruptcy. There are also several upfront fees that come with filing for bankruptcy that can add up to many hundreds of dollars.
  5. Your co-signers are not protected: We can’t forget about the people who helped us financially by co-signing for our loans or other lines of credit. Co-signers and guarantors aren’t protected from collection on debts that you discharge through bankruptcy. You can be alleviated of these debts, but a family member or friend may get harassed over the remaining balance unless you pay it off. This isn’t guaranteed to happen, but it’s definitely something to keep in mind. Just make sure to have a conversation with anyone who co-signed a loan with you before you file, so you can handle the situation together.
  6. Borrowing in the future can be challenging: Having a bankruptcy remark on your credit report can present a challenge when trying to borrow money for as long as a decade. Lenders can view bankruptcy marks as a sign of irresponsibility with finances and might be hesitant to work with you. Be aware that bankruptcy can cause obstacles when working to buy a home, a car, or even applying for a credit card down the line

FAQs

Can I keep my car when I file for bankruptcy?

Since a car is a necessity for most people, you may be wondering if it’s taken away when you file for bankruptcy. Your car is considered an asset since it has value, and a car loan is a secured debt that the lender can take back if you don’t pay.  

If you file for Chapter 7 bankruptcy, and local bankruptcy laws allow you to exempt all of the equity you have in your car, you may be able to keep the vehicle as long as you’re current on your loan payments. Those filing Chapter 7 can also “reaffirm” their loan or buy the car outright. Chapter 13 allows people to continue to pay their car loan, and other debts, under a structured plan. 

Is it better to file a Chapter 7 or Chapter 13 bankruptcy?

This is a great question to ask yourself when contemplating bankruptcy as an option; however, it’s generally circumstantial. In a lot of cases, Chapter 7 bankruptcy can be a better fit for people rather than Chapter 13. Since Chapter 7 is much faster, many fillers end up keeping most of their property and don’t have to pay back the creditor through a multi-year repayment plan like Chapter 13 requires. Ultimately, it depends on what you’re eligible for and what makes the most sense for your current income and finances.

Can I improve my credit after filing for bankruptcy?

The short answer is yes. Usually, you can continue to improve your credit score over 12 – 18 months after bankruptcy. Most people will see some improvement after 1 year if they take the right steps. Start with smaller goals toward bettering your credit, and you will see your score start to improve over time! 

Final Thoughts

You’re not alone as you consider filing for bankruptcy and weigh the options. Although it’s a huge decision that will impact your financial health, there are people along the way that can help guide you through the process. But, before making an impulsive decision, it’s worth consulting with a professional credit counselor to guarantee you’re well-informed and aware of the drawbacks that come with each type of bankruptcy. 

Speaking with a lawyer before making your mind up may also be a wise investment and a good place to start. Take a step back and look at your financial situation to ensure you have the support that you need while working to improve your finances and lifestyle!

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