When Should You File Bankruptcy Rather than Pay Off Your Debt?

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Few financial words sound scarier than “bankruptcy.” And for good reason. Declaring bankruptcy is extremely serious, and it shouldn’t be anyone’s first course of action when dealing with money problems or debt.

But for some, this action could provide a solution to serious debt situations. In extremely simple terms, you can file bankruptcy when you owe more money than you can afford to repay.

Of course, the process gets complicated. Only a select group of individuals will find this option feasible, and you should only pursue this course after learning more about what happens when you file bankruptcy instead of paying off your debt.

That being said, let’s dive into this issue to better understand if it’s the right path for you and the debt you hold.

What Is Bankruptcy, Anyway?

Bankruptcy is more than a term: it’s the legal status that applies to you if you are unable to pay off outstanding debt. A court must grant this status.

When you file bankruptcy, you enact a process that allows consumers (and businesses) to eliminate some or all of the total amount of money they owe under the protection of the federal bankruptcy court. There are two main forms that you file for: Chapter 7 and Chapter 13.

In both, you’ll likely need to undergo debt counseling before starting the legal process. (You can find a list of counselors by state here.)

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Chapter 7 Bankruptcy

Chapter 7 bankruptcy starts a process of asset liquidation. You must liquidate all your assets in order to pay off as much debt as possible.

In other (and simpler) words, you enter an agreement that you’ll give up your assets and in exchange you get to discharge some of your debts. This isn’t a great option for those who want to maintain what they currently possess, although there are exemptions for your property (including your clothes, your car, and some household items).

Your liquidated assets go toward repaying your unsecured debt in Chapter 7 bankruptcy. For secured debts, like auto loans, you have a few more options.

You can allow the creditor to take possession of the property (i.e., your car) or pay a lump sum equal to the replacement value of the property. You might also be able to negotiate a payment plan and continue making payments on the amount you owe.

You can file for Chapter 7 bankruptcy only once every six years. This option can help those who have few assets and low income, but a large amount of debt.

Chapter 13 Bankruptcy

The other type of filing available to consumers is Chapter 13 bankruptcy. In this case, the focus is on reorganizing your debt instead of liquidating your assets in order to repay your debt.

This process allows you to temporarily hit pause on debt collections and foreclosures as you work to restructure your debt into a new repayment plan. This plan requires you to repay your debts over a period of three to five years, and may allow you to discharge some of what you owe.

How much of your debt that gets discharged is based on the amount of money you make in regular income. It’s not based off how much total debt you hold — although there are debt limits in place. If the amount of money you owe exceeds a certain point, you may not be eligible for Chapter 13.

What Affects Does Bankruptcy Have on Finances?

Again, bankruptcy is complicated and it does have consequences for your finances. There may be upfront costs — while it’s not necessary to hire a lawyer, bankruptcy is a legal proceeding and having professional representation is recommended.

With Chapter 7 bankruptcy, you can lose possession of valuable assets if you have them. This may or may not be worth shedding the debt you hold. With Chapter 13, you’ll still need to continue making repayments on your debt under your restructured plan for 3 to 5 years.

And the process can seriously damage your credit now and in the future. If you file bankruptcy under Chapter 7, it stays on your credit score for 10 years. Chapter 13 bankruptcy hangs around for 7 years. This means if you have a good credit score in the 700s now, you can expect a drastic drop — sometimes by 100 points or more.

This could make it difficult to qualify for loans in the future, and any money borrowed could cost you more via high interest rates if lenders see you ask a risk due to past bankruptcy filings.

Should You File Bankruptcy?

If you’re in debt and thinking about bankruptcy, step away from this post — and from filing anything — if you:

  • Can pay more than the minimum payments on your loans and card balances.

  • Repay your debts on time each month and are not behind on payments.

  • Understand where you are with your debt: you know how much you owe and how much you can afford to repay each month because you have a plan in place.

Bankruptcy isn’t a causal solution and it’s not appropriate for everyone in debt. Additionally, bankruptcy doesn’t treat all debt equally. The process will not discharge debts from:

  • Child or spousal support

  • Debts you incur after you file bankruptcy

  • Some debts you incurred six months prior to filing bankruptcy

  • Debts from causing other people injury while driving intoxicated, or from willful, malicious injuries to others

  • In some cases, student loans and taxes

But if you couldn’t tick off any of the above, and don’t hold any of those types of debt, it may be time to explore this option further.

You should only consider bankruptcy when you’re in a dire situation with your finances. It’s a worst-case scenario, a last resort. That means you feel your debt is completely out of control and you:

  • Can’t afford payments on your debt at all; you can’t afford the minimum payments.

  • Are severely behind in your monthly payments despite your best efforts to cut costs, budget, and repay your debt.

Bankruptcy may be able to help if you’re in this situation and you feel you have no other options.

However, you need to think about your own money management habits before proceeding. Ask yourself: how did you get into debt in the first place? Are you continuing to accumulate debt through consumer spending, even though you know your finances are in trouble?

If you can’t manage your credit cards, loan balances, or develop good financial habits before declaring bankruptcy because of out-of-control spending or poor money management, this process will only be a band-aid and not a long-term solution to deeper-seeded financial issues.

You should also ask yourself what bankruptcy will mean for you and your finances in the future. The process can ruin good credit, making it difficult to secure financing for up to a decade after you file. Will this impact your future financial goals, or will filing help you towards a better financial situation in the coming years?

Bottom line: proceed with caution. Continue doing research and asking questions to ensure you explore other alternatives before you file bankruptcy rather than pay off debt.

Image credit: mendhak

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  • anonymous

    “What *EFFECT* …?”

  • really great article with awesome information

  • SteveH

    worthless article. no reasons listed for either way…

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