Between what is portrayed on TV and movies, along with the misguided advice of well-meaning friends, bankruptcy is a process that is surrounded by a lot of misconceptions.
Around 2014 I had amassed what I considered a small fortune in debt, and it was really stressing me out. After hearing my tale of financial woe, my friend Taylor blurted out “Why don’t you just declare bankruptcy?”.
He said it in a tone that made it seem like it was the most obvious thing in the world. Was I missing something? Was declaring bankruptcy as painless as this guy is making it sound?
“Won’t that like...ruin my credit?” I said.
He shook his head. “Nope, my cousin did it. He said there were almost no consequences.”
I have no doubt that Taylor meant well with this advice, but it certainly was not coming from a place of experience. The statement that there are “almost no consequences” is completely false.
If your debt has gotten to a point where you feel like it’s truly insurmountable, it might be time to consider filing for bankruptcy, but it’s crucial that you understand the impact that it will have on your financial situation for years to come. Read on to learn more about your different options, as well as the pros and cons of filing for bankruptcy.
What is bankruptcy?
Bankruptcy is a legal process where a person or business seeks relief from outstanding debts that they are unable to pay. In most cases, the legal proceeding starts with a petition filed by the debtor (person who owes the money), and then a court evaluates the debtor’s finances to determine how much of the outstanding debt can be paid off with their existing assets.
There are various types of bankruptcy, often referred to by their respective chapters within the U.S. Bankruptcy code.
While bankruptcy does offer people freedom from crushing debt, it’s important to note that this filing stays on your credit report for between 7-10 years, and comes with some significant drawbacks which we go over in detail below.
For the purposes of this article, we’re going to focus on the bankruptcy process for private citizens as opposed to business entities.
What are the benefits of bankruptcy?
Most importantly, filing for bankruptcy will provide significant debt relief for those who are in over their heads. The relief will depend on the filing type you choose, but the main advantage is that you’ll put a stop to the “bleeding” of money that your debt is causing.
A lot of people tend to lose hope the further into debt they go, but bankruptcy is a beacon of light that can make a disastrous situation manageable again.
Filing for bankruptcy triggers what’s referred to as an “automatic stay”, which temporarily freezes all repossession actions.
This temporary hold can give you an opportunity to catch up financially and sort things out before your home or other property is repossessed.
Depending on your specific case, your bankruptcy filing may be able to protect some of your assets. For instance, if you file for Chapter 7, your home and vehicle may be exempt from liquidation.
Silence the debt collectors
Part of an automatic stay also prevents debt collectors from contacting you further while you’re in the filing process. Once you file, you won’t have to worry anymore about the endless barrage of phone calls and letters from your creditors.
Learn more about the fair debt collection practices act here.
What are the drawbacks of bankruptcy?
For as many benefits as bankruptcy has, there are also significant disadvantages that you should consider ahead of time.
It can lead to the loss of property
It’s likely that as part of your bankruptcy proceedings, you may be required to sell some of your possessions in order to repay your debts. This doesn't mean that you’ll lose everything you’ve ever worked for and will be forced to sell the shirt off your back, but if you’re filing for chapter 7, you should prepare yourself to part with some non-necessities.
Asset liquidation varies greatly from case to case and will depend on the type of bankruptcy you file for. While in some cases you may be able to keep your home and your vehicle, you shouldn’t bank on being able to keep anything that a court might view as excessive or living beyond your means.
It will damage your credit report for years
Depending on which chapter you choose, you can expect a bankruptcy filing to stay on your credit report for between 7-10 years. You should also expect your credit score to drop at least 200 points as a result of your filing.
As you can imagine, this impact to your credit report will make it more difficult to borrow money in the short term. Since financiers will view you as a higher risk, you should expect difficulty obtaining lines of credit and an increase in your interest rates while you begin to rebuild your credit score.
It can make it harder to rent a home
It’s common knowledge that filing for bankruptcy can impact your ability to obtain a mortgage in the short term, but what if you’re a renter?
If you are searching for a new apartment or home to rent, it’s likely that your landlord will check your credit history as part of the application process. A recent bankruptcy filing could result in a higher security deposit, increased monthly rent, or denial of your application.
It could make it more difficult to get a job
Some employers have incorporated an assessment of a candidate’s credit history into their background checks.
While there are varying schools of thought regarding whether a credit score is an accurate representation of an applicant’s trustworthiness, it is something that a growing number of employers are looking at.
The types of bankruptcy
Now that we’ve covered some of the pros and cons, let’s take a look at the two main types of bankruptcy that people file for.
Chapter 7 is commonly referred to as “straight bankruptcy” and is generally considered to be the quickest and easiest way out of debt according to author, and debt expert, Steve Rhode.
With this type of bankruptcy, you’ll be required to work with a representative from federal bankruptcy court to sell any assets that aren’t exempt. Exempt items can include things like your vehicle, work tools, and basic necessities. The proceeds from your asset liquidation goes toward paying off your debts, and the balance of what you owe will be wiped clean after your bankruptcy is discharged.
Chapter 7 bankruptcy will stay on your credit report for a period of 10 years from your filing date, and you won’t be able to file for chapter 7 again for a minimum of 8 years.
Chapter 13 is different from chapter 7 in that you are able to keep your property in exchange for paying back your debt partially or completely.
With this type of bankruptcy you’ll agree to a repayment plan with your creditor(s) spanning 3-5 years. During the negotiation phase of the filing process, you may be able to get your outstanding balance reduced so that you only have to pay back a portion of your debt. Once you’ve finished making payments toward your payment plan your debt will be discharged.
Chapter 13 is often seen as a more palatable option for filing for bankruptcy. This filing method is sometimes referred to as a “pause button” so that you can stop your debts from accruing more interest as you work toward paying them back on an extended timeline. Additionally, you generally have more freedom to keep your assets with this type of filing if you can find other ways to fulfill the terms of your repayment plan.
Chapter 13 bankruptcy falls off your credit report after 7 years and you can file again for this chapter just 2 years after your original filing date.
Do I need an attorney to file for bankruptcy?
No. You can file for bankruptcy on your own, which is referred to as “pro se”.
While it’s not required to hire a bankruptcy attorney, they can be quite helpful in navigating the process, and letting you know ahead of time what kind of results you might expect. They’ll also advise you on which chapter you should file for, whether or not your debts are eligible to be discharged, and what the potential consequences of your filing will be.
Can I discharge student loans with bankruptcy?
It was once thought to be impossible to discharge student loans through a bankruptcy petition, but that tide could be shifting following a major 2020 decision that saw a Navy veteran relieved of $221,385.49 in student loans under chapter 7 bankruptcy.
However, bankruptcy is not the only strategy available to help with student loan debt. Check out our article on student loan forgiveness for more options.
What types of debt can’t be discharged by bankruptcy?
There are a few different types of debt that are not discharged by a bankruptcy petition.
- Debts you failed to list on your bankruptcy filing
- Child support & alimony
- Instances of fraud
- Debt arising from deliberate injury of another person or property
- Debt stemming from death or personal injury caused by DUI
- Certain unpaid taxes and tax liens
A final word on bankruptcy
Filing for bankruptcy can provide much needed relief and is not something to be ashamed of. Plenty of people, including our Zero Debt founder have filed for bankruptcy and then bounced back stronger than ever. That being said, this decision should be considered as a last resort and the benefits should be closely weighted against the consequences.
If you’re considering filing for bankruptcy but aren’t sure if you’ve exhausted all other options, the following articles may be able to help.