Filing for Bankruptcy: Pros and Cons

Filing bankruptcy isn’t right for everyone. One of the first questions you’ll need to ask is whether you’re eligible to file.

First, you must pass a means test to file a bankruptcy case. This test determines if you have the “means” to pay your debts by measuring your income and expenses. You “pass” the test if you don’t have enough disposable income to realistically pay your debts. Means testing is required for both Chapter 7 and Chapter 13 bankruptcy.²

You also need to have debts that can be included in a bankruptcy filing. Here’s a quick rundown of debts that can and can’t be discharged in bankruptcy.

Student loans are a gray area where bankruptcy is concerned. While it’s technically possible to discharge them, it’s often difficult. You must demonstrate a significant and ongoing financial hardship that prevents you from repaying your loans.⁴

Talking to a bankruptcy attorney might be helpful if you’re debating whether to file. Some bankruptcy attorneys offer a free initial consultation to discuss your options.

There are advantages and disadvantages to consider before you file for bankruptcy versus choosing another path for managing debt. Here’s how the pros and cons compare.

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 allow you to repair your financial reputation and rebuild your credit scores while relieving pressure on your budget. You might appreciate that if you have other financial obligations to manage, such as child support.
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 only take action against you once your case is finalized. This provision protects you from lawsuits, repossession, or even foreclosure. You avoid dealing with creditors and debt collectors blowing up your phone if you have delinquent accounts.⁵
3. Potentially consolidate or discharge debts: Bankruptcy could help with consolidating your debts into more manageable payments or by writing them off completely. Either option may help relieve some financial-related pressure.

Cons

1. Your credit score will drop: Chapter 7 and Chapter 13 bankruptcy can leave a black mark 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 seven years. Credit bureaus can’t just remove this information for you; you’ll have to wait for it to fall off your credit file.⁶
2. Your assets can be taken: With some types of bankruptcy, you could lose your income and the equity in your assets, especially luxury items like vacation homes, a second car, jewelry, and household furnishings. Some assets are exempt, but you might have to give up money in your bank account or household items.
3. Not all debts will be discharged: If you think bankruptcy will automatically take care of all of your debt, it won’t. Bankruptcy can be used to erase liabilities like personal loans, credit card bills, and other unsecured debts, but it will leave student loan debt, taxes, and other debts in play.
4. Bankruptcy can be costly: Bankruptcy helps offer debt relief, but it isn’t free. For example, you can pay hundreds or thousands of dollars to address the cost to file, the cost of an attorney, administrative fees, filing fees, trustee fees, and other expenses that can vary based on state. And if you file for Chapter 13 with a repayment plan, you’ll have payments for years after you file.⁷
5. Your co-signers are not protected: 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 something to remember.
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. Buying a house, returning to school, or even applying for a credit card can all be more difficult when your credit scores have dropped.

Federal bankruptcy exemptions to know

Filing Chapter 7 bankruptcy could mean having to hand over some of your assets. The bankruptcy court liquidates those assets and uses them to pay your creditors. There are, however, limits on which assets the court can take.

Federal bankruptcy exemptions exclude the following:

• Home equity (which is the difference between what you owe on your home and what it’s worth)
• Motor vehicles
• Jewelry
• Household goods, furnishings, appliances, clothes, books, animals, crops, and musical instruments
• Tools of the trade
• Health aids
• Cash value that’s accumulated in a life insurance policy
• Proceeds from a personal injury settlement owed to you
• Spousal support or child support you receive
• Life insurance payments that are required for your support
• Social Security benefits, unemployment benefits, veteran’s benefits, public assistance, and illness/disability benefits
• Retirement accounts⁸

There’s also a wildcard exemption you can apply to anything you own that’s not covered by one of the above exemptions. The wildcard allows you to safeguard items of your choosing, up to the limit allowed by your state.

States have their own bankruptcy exemptions. Whether you have the option to choose from state exemptions or federal exemptions depends on where you live. If federal bankruptcy exemptions don’t apply in your state, you’ll have to follow the guidelines established by state law.⁹

If you’re convinced that bankruptcy is the right move, there’s a process that you’ll go through. It looks something like this.

• Credit counseling. You’ll first need to meet with a credit counselor, who will review your financial situation and help you decide if bankruptcy is the right option. The Department of Justice’s U.S. Trustee Program maintains a list of approved counselors.¹⁰
• Filing the petition. If your credit counselor advises bankruptcy, the next step is filing a petition with the bankruptcy court nearest to where you live. This is something a bankruptcy attorney can help with, though you’re not required to have an attorney to file.¹¹
• Case review. A bankruptcy judge will review your case and schedule a meeting of creditors. This meeting allows your creditors an opportunity to challenge your bankruptcy filing. If there are no challenges, the bankruptcy judge will decide on whether your debts should be discharged.
• Bankruptcy discharge. Discharge means your case is finalized with the bankruptcy court. In a Chapter 7 bankruptcy, any debts included in the filing would be erased, and you’d no longer owe them.¹² In a Chapter 13 bankruptcy, you’d need to make agreed-upon payments to your credits over a period of either three or five years to satisfy your debts and obtain a discharge.¹³

There are several different types of bankruptcies that individuals and businesses can use to manage their debts. The one that you choose can depend on your situation.

Chapter 7: Liquidation

Chapter 7 bankruptcy, also known as liquidation, allows you to clean the slate on most debts. This type of bankruptcy is most common for individuals rather than businesses.

In a Chapter 7 filing, a court-appointed trustee works with you to collect your non-exempt assets for liquidation. You might consider a Chapter 7 filing if you don’t have a lot of assets to lose or mostly owe unsecured debts that you can no longer pay.¹²

Chapter 13: Repayment plan

Chapter 13 bankruptcy is a structured repayment plan where your debts are reorganized. Individuals and businesses can use Chapter 13 bankruptcy to pay off debts without having to sell any assets.

You must submit a monthly payment plan to the bankruptcy court for approval. The monthly payment amounts will depend on your income and the amount of debt you have.¹³

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

Chapter 9: Municipalities

Chapter 9 bankruptcy is a repayment plan option that allows municipalities (towns, cities, schools) to reorganize and pay back their debts, but specifics can vary by state.¹⁴

Chapter 11: Large reorganization

Chapter 11 bankruptcy is mostly used to reorganize businesses or corporations’ debts. With this chapter, businesses devise a plan for how they’ll continue to operate the company while paying off their debt.

The court and the creditors must approve the plan, allowing the filer to draft an arrangement to repay some debt while retaining assets.¹⁵

Chapter 12: Family farmers

Chapter 12 bankruptcy is a repayment plan for family farmers and fishermen that can allow them to reorganize their debt without selling their assets or properties. A family farmer or fisherman can be an individual, an individual and their spouse, or a corporation that runs a farming operation or a commercial fishing business that generates annual income. If you’re a backyard hobby farmer, you’d need to consider Chapter 7 or Chapter 13 instead.¹⁶

While similar to Chapter 13 bankruptcy, Chapter 12 is more flexible and has higher debt limits. Repayment usually stretches out over three years, but a court can also decide to extend the repayment period up to five years.¹⁶

Bankruptcy is often viewed as a last resort option for dealing with debt rather than a first choice. That’s because there are other ways to tackle debt that don’t require you to go through a court proceeding or hurt your credit.

Some of the alternatives you might consider include:

• Enrolling in a debt management plan (DMP). Debt management plans allow you to combine multiple debts into one with the help of a credit counselor. You make one payment to the counselor, who distributes it among your creditors to help you get out of debt faster. You might choose this option if you mainly owe unsecured debts like credit cards.
• Debt consolidation. Debt consolidation involves taking out a personal loan to pay off other debts. In doing so, you can streamline the number of debt payments you have to make each month and potentially save money on interest if your debt consolidation loan has a low interest rate.
• Debt settlement. Debt settlement allows you to get out of debt for less than what you owe. You can settle debts on your own or with the help of a debt settlement company. This option could be attractive if you’ve fallen behind on debt payments and will likely default on what you owe.

Again, talking to a bankruptcy attorney can help you size up all the options. If you cannot book a meeting with an attorney, try contacting a local, nonprofit credit counseling organization instead. A credit or debt counselor can help you evaluate which path is best for you.

Bankruptcy is often viewed as a last resort option for dealing with debt rather than a first choice. That’s because there are other ways to tackle debt that don’t require you to go through a court proceeding or hurt your credit.

Some of the alternatives you might consider include:

• Enrolling in a debt management plan (DMP). Debt management plans allow you to combine multiple debts into one with the help of a credit counselor. You make one payment to the counselor, who distributes it among your creditors to help you get out of debt faster. You might choose this option if you mainly owe unsecured debts like credit cards.
• Debt consolidation. Debt consolidation involves taking out a personal loan to pay off other debts. In doing so, you can streamline the number of debt payments you have to make each month and potentially save money on interest if your debt consolidation loan has a low interest rate.
• Debt settlement. Debt settlement allows you to get out of debt for less than what you owe. You can settle debts on your own or with the help of a debt settlement company. This option could be attractive if you’ve fallen behind on debt payments and will likely default on what you owe.

Again, talking to a bankruptcy attorney can help you size up all the options. If you cannot book a meeting with an attorney, try contacting a local, nonprofit credit counseling organization instead. A credit or debt counselor can help you evaluate which path is best for you.

Can I keep my car when I 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. Whether you keep your car or not depends on which bankruptcy chapter you file.

If you file for Chapter 7 bankruptcy, 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 loans and other debts under a structured plan.

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

Chapter 7 bankruptcy can be a better fit for people who don’t have a lot of assets or mostly owe unsecured debts. Filers can exempt certain assets and cancel debts without committing to a lengthy repayment plan. However, if you have assets you’d like to keep, then a Chapter 13 filing would allow you to do that.

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 one year if they take the right steps. Starting with smaller goals toward bettering your credit, like opening a secured credit card, can help you get back on track following a bankruptcy proceeding. You can check your credit regularly to see what kind of progress you’re making.