Personal bankruptcy is often considered as a last resort option after an individual has gone through difficult financial circumstances. Typically, the assumption is that bankruptcy results from financial irresponsibility and abuse of extended credit. However, that is not always the case.
People file bankruptcy for a variety of reasons including unemployment, divorce, and medical expenses. In fact, in 2019, CNBC reported that two-thirds of bankruptcy filings cited medical issues as the reason.
If one of the above reasons has you thinking about filing for personal bankruptcy, there are some key factors you need to consider first before starting any bankruptcy proceedings. Declaring bankruptcy is not a decision to take lightly as it comes with long-term consequences. These consequences can be very limiting and impactful to you as the filer.
As a result, it's important that you are well informed about the process and consider all your alternative options as well. This blog post will break down the key things you need to know.
- What is bankruptcy
- How is bankruptcy declared
- Different types of personal bankruptcy
- How to file bankruptcy
- Consequences of filing bankruptcy
- Qualifying for a loan or credit card after filing for bankruptcy
- Alternatives to bankruptcy
- Life after bankruptcy: Steps to recovery
What is bankruptcy?
When a person is unable to pay debts they owe, they are considered bankrupt. Bankruptcy is a legal process that is handled through federal courts in the United States. During this process, judges known as bankruptcy judges make the final decisions on cases including whether an individual is eligible to file for bankruptcy or not.
Bankruptcy is typically reserved for situations where a borrower is in excessive debt that they are unable to overcome. For instance, if you are facing foreclosure on your home or are unable to pay your other financial obligations.
How is bankruptcy declared?
Bankruptcy is declared by the individual who is in debt / owes money. In order to begin bankruptcy proceedings, you will need to file a bankruptcy petition to initiate the process. Once the application is received, you will need to appear before a court and explain the circumstances that led you into your present financial circumstances.
Different types of personal bankruptcy
There are different classifications for bankruptcy that a debtor can file under and these largely depend on one’s circumstances. Broadly speaking, the two main categories are Chapter 7 and Chapter 13 bankruptcy which are explained below.
Chapter 7 bankruptcy
Under chapter 7 bankruptcy, consumers, with low incomes can apply to erase some of their debts. This form of bankruptcy is known as liquidation bankruptcy. This means that many of your assets will be sold off in order to pay the debt.
A trustee is chosen to manage this process and only assets that are not exempt are put up for sale. Examples of exempt assets could include the equity in your home, a pension or a vehicle up to a certain amount. Once the trustee has sold all the eligible assets and used the proceeds to pay off outstanding debt, the remaining debt is forgiven.
Chapter 7 bankruptcy does contain some minimum conditions that must be met before anyone can file and these include:
- You have not previously filed for Chapter 7 bankruptcy in the last 8 years and,
- You must be able to pass a means test which essentially determines if your income is low enough to qualify for Chapter 7 bankruptcy.
Once these conditions have been met, a formal process of classifying the debt begins. In this process, debt is categorized as secured and unsecured. Within each category, outstanding obligations are then ranked based on priority for payment.
Unsecured debts (debt not backed by any assets) are given a higher priority in bankruptcy proceedings. These include tax obligations, child support and personal injury claims made against the debtor. After the unsecured debt has been paid off, the secured debt (debt backed by assets e.g. mortgages) is next in line.
Chapter 13 bankruptcy
This type of bankruptcy is a less severe form of bankruptcy and is sometimes referred to as the wage earners bankruptcy. As the name implies, this bankruptcy is reserved for those with an income who can pay all or part of their financial obligations without having their assets repossessed.
This particular type of bankruptcy helps borrowers who have access to funds but are under pressure from their creditors to pay back their debts as soon as possible.
With Chapter 13 bankruptcy, you have 3 to 5 years to pay back your outstanding obligations and you are required to use all your disposable income to meet your monthly payments. In line with this, you'll need to submit what is known as a reorganization or repayment plan.
Similar to Chapter 7 bankruptcy, a trustee is appointed to manage the finances and this trustee is responsible for collecting payments from you the debtor and paying the creditors their money. This type of bankruptcy might appeal to you if you are concerned about losing your home to foreclosure and want to keep your assets in place.
How to File for Bankruptcy
How to file for Chapter 7 bankruptcy
To file for Chapter 7 bankruptcy, you will need to go through the following steps outlined below. The entire process will take you about 4 months to complete. To get started, it is essential to find and work with an experienced bankruptcy attorney. The steps are as follows:
- Step 1: File a petition with a local bankruptcy court along with all of your financial statements. This would include all your income, list of debts, lists of assets, recent tax returns, etc.
- Step 2: Complete the required bankruptcy counseling. This typically costs $50 to complete. Other costs include a filing fee of ~$335 for the petition (as of 2019), court fees, and attorney fees.
When evaluating the cost of filing for bankruptcy, it may be tempting to file the required paperwork on your own. However, the importance of working with a qualified attorney cannot be overstated. Working with a qualified professional is worthwhile. Especially because of the paperwork required to go through the process coupled with the potential that it could get rejected by the bankruptcy court if paperwork is filed incorrectly.
How to file for Chapter 13 bankruptcy
To file Chapter 13 bankruptcy, you need to follow the steps outlined below. Before you start, you need to ensure that your unsecured debt e.g. credit cards, personal loans, etc, do not exceed $394,725 and your secured debt does not exceed $1,184,200. These thresholds are periodically reviewed to keep up with inflation.
- Step 1: Find a bankruptcy lawyer. You can often get a free evaluation from most lawyers to see if they would be a good match to work with.
- Step 2: File your petition and pay the required filing fee. This fee is currently at $235 (as of 2019) and goes to the bankruptcy court. In addition, an administrative fee of $75 is also required.
- Step 3: Provided all accompanying paperwork which would include:
- A list of the outstanding creditors and the amounts you owe each of them.
- Evidence and paperwork detailing your income.
- A list of your assets such as property and vehicles (If there are any contracts
in your name, these will need to be provided as well).
- A list of your monthly living expenses.
- Your most recent tax returns and a statement showing your unpaid taxes.
Consequences of filing bankruptcy
Choosing to file for bankruptcy is not an easy decision to make and it is one to take seriously. Specifically making sure you have a good understanding of the potential consequences. Some of the major consequences of filing for bankruptcy include:
- Limited ability to borrow money in the future. Once you’ve gone through bankruptcy proceedings, it will be extremely difficult to gain access to any lines of credit as a permanent public record will exist in your name. If you’re not used to a lifestyle of paying for items in cash, this may prove to be a challenge for your lifestyle going forward as credit cards are very commonly used in society.
- Your credit report will display your bankruptcy record for up to 10 years. This is stipulated in the Fair Credit Reporting Act which allows credit agencies to report bankruptcy. Not only will this impact your ability to take out loans in the future, but it could also have a limiting impact on your career as creditors run background checks during the employment process.
As you embark on the bankruptcy journey, it is imperative to get a copy of your credit reports from each of the 3 agencies (Equifax, TransUnion, and Experian) both before and after the process. This is to ensure that your information in their records is correct. Doing so could minimize any challenges in the future.
Qualifying for a loan or credit card after filing for bankruptcy
While bankruptcy might not be the easiest process to navigate, going through it does not have to spell the end of your relationship with credit. There are steps that you can take to build your credit back to a healthy level.
Check your credit
As mentioned above, the best place to begin is to check your credit reports to ensure they accurately reflect your financial circumstances. The reports will need to reflect the bankruptcy as well as the show a record that the debt has been released.
Option 1: Leverage a secured credit card
The next step, if you’re looking to get a credit card, is to apply for a secured card. A secured credit card is an excellent way to rebuild your credit. Financial institutions are comfortable with issuing this form of credit because it is backed by funds in your bank account. The funds serve as the credit line for the card and should you ever default, the funds can be drawn on as collateral.
An alternative way to get a credit card would be to work with a friend or family and be added as an authorized user to that person’s credit card account. The primary cardholder remains with the sole responsibility of paying off the card. However, the authorized user benefits from the boost to their credit score if the account is paid on time.
It is advisable to check with the credit card company to confirm if the account will be added to your credit history as an authorized user. Making payments on time and ensuring that these are reported on your credit history are the best ways to ensure you gain the benefits from this arrangement.
Option 2: Leverage a credit-builder account
Another alternative to improve your credit score the point where you can apply for a credit card would be to leverage a credit-builder account. A credit-builder account, also known as a credit builder loan, is a small loan taken out in your name. However, instead of the funds being disbursed directly to you, the credit-builder account issuer holds onto it in the form of a secured loan by placing your money into a certificate of deposit.
Alternatives to bankruptcy
Deciding whether to file for bankruptcy or not can be a tough decision. If you’re wondering what to do, it may help to know that there are alternative options out there. Some options include:
Debt management plans
You might be able to negotiate a debt management plan where you as the debtor are able to pay back the full principal over an agreed-upon period of time. This creates a monthly payment plan that is tailor-made to cover your specific needs and it can help to provide some structure to your payment process. One thing to note however is that the lender is under no obligation to agree to it.
Done correctly, debt consolidation combines all your outstanding debts into one lump sum with a lower interest rate and a more sustainable monthly payment. Debt consolidation is typically in the form of a loan and the interest rates are typically much lower than those charged by individual credit card companies.
This is an alternative to debt consolidation. Debt settlement seeks to allow a debtor to make a lump sum payment that is usually less than what the debtor currently owes. This amount is typically 50 – 75% of the original value of the debt. Lenders will report this as “settled for less than agreed” to the credit bureaus. This record will remain a part of your credit report for seven years.
Even with bad credit, you can apply for a personal loan depending on the specifics of your situation. However, interest rates will be incredibly high and so will the monthly payment. So you'll need to determine if this option is right for you.
Life after bankruptcy: Steps to take to recovery
Once you have completed the bankruptcy process, you may want to rebuild your credit. While this is possible, it is also advisable to do so cautiously. Some steps to ensure a healthy relationship with money include making sure you have firm boundaries when using a credit card to make purchases.
Additionally, you want to make sure you are paying off your card at the end of every month without question. Prioritize only making purchases on your credit card that you can pay off in full each month, and follow through on doing so.
Learn to budget
Budgeting should naturally become a key component in your tools to successfully navigate life after bankruptcy. While budgeting takes discipline, it is much easier with a range of tools to assist with the process. For some, working with pen and paper may be optimal while for others, using online tools might be optimal. Other strategies such as automating your bills and savings will help to ensure that you’re meeting your obligations consistently.
Build up your emergency savings
Emergencies undoubtedly arise and having a robust emergency fund in place goes a long way. An emergency fund can be established by saving money in a separate account that you don’t necessarily have instant access to. The recommended amount to get started with is $1,000 with a goal to get to 3 to 6 months of your core living expenses.
When it comes to filing for bankruptcy, it's important to take all of the above into consideration. And also to attempt to fully exhaust all your alternative options. It's also very important to remember that to improve your financial situation you will also need to improve your money management skills, mindset and, self-discipline.