Bankruptcy may be a measure of last resort, but for those who are buried in bills, it can also be an important steppingstone to financial wellness.
“Consumers in debt should always look for alternatives to bankruptcy because there are consequences. But if it’s a smart play that benefits them, they should not be afraid of it either,” said Charles Bullock, a bankruptcy attorney with Stevenson & Bullock in Southfield, Michigan. “They should instead immediately start planning for life after bankruptcy. That includes rebuilding their credit.”
Indeed, those considering bankruptcy must make smart choices both before and after they file to restore their financial stability as quickly as possible. They should also avoid certain moves that may jeopardize their ability to seek relief from creditors in court. The list of do's and don’ts includes the following:
- Consider alternatives.
- Create a personal balance sheet.
- Consult a professional.
- Be honest.
- Rebuild your credit.
- Intentionally incur debt before bankruptcy.
- Transfer your assets prior to filing.
- File for bankruptcy while accumulating debt.
- Pay creditors with retirement savings.
What is bankruptcy?
Bankruptcy is the legal process of seeking relief from creditors by reducing or eliminating debt, giving those who can no longer keep up with their payments an opportunity to begin anew.
By filing for bankruptcy, you may be able to discharge, or wipe out, many of your unsecured loans (including credit card balances), stop foreclosure on your home, and stop vendors from shutting off your utility services.
What happens when you file for bankruptcy?
Once you file a petition for bankruptcy in court, your creditors will automatically be notified and will be forced to halt collection activity against you (including phone calls and wage garnishments) for payments on medical bills, credit card debt, personal loans, and other debt. The court will then assign a bankruptcy trustee to handle your case and you will be required to submit details of your complete financial picture including your list of creditors, total debt, income, and expenses.
Can you file for bankruptcy without an attorney?
According to the United States Courts website, individuals can file for bankruptcy without an attorney, which is called filing pro se, but it can be difficult to navigate the legal process alone. As such, the government notes that “seeking the advice of a qualified attorney is strongly recommended because bankruptcy has long-term financial and legal outcomes.”
Nonprofit group Debt.org reports that most cases of bankruptcy aren’t caused by reckless spending, but by financial hardship brought on by an unexpected job loss or a major expense. In such cases, those living paycheck to paycheck may find themselves trapped in a cycle of high-interest credit card debt or payday loans, making it impossible to dig out. (Learn more: The dangers of payday loans)
The U.S. bankruptcy code allows for three types of personal bankruptcy protection for individuals:
- Chapter 7 is the process of discharging your unsecured debt and converting your nonexempt assets into cash to distribute among your creditors. That may include credit card balances, medical bills, and unsecured personal loans. Generally speaking, it does not include child support, alimony, court fees, certain tax debts, and most student loans.
- Chapter 13 governs the process of reorganization in which individual debtors with regular income can potentially keep their property (such as their home) and create a plan to catch up on late payments, often in three to five years.
- Chapter 11, which is typically used by corporate debtors, governs the process of reorganization in which an individual debtor may potentially protect their assets by restructuring their debtor-creditor relationships. Individuals who file for Chapter 11 typically do so because the amount of their unsecured debts or real estate debt exceeds the limit for Chapter 13 protection.
Wiping out your debt sounds like a simple solution for those who are struggling financially, but Armando Sallavanti, a financial professional with MassMutual Greater Philadelphia, said consumers should not treat it lightly. A Chapter 7 bankruptcy filing stays on your credit report for 10 years, while a Chapter 13 filing stays on your record for seven years, making it difficult to obtain new loans or secure a credit card with a reasonable interest rate during those years.
And while federal laws prohibit both public and private sector employers from firing a current employee based on a bankruptcy filing, private employers that require job applicants to submit to a background check may take your credit status into consideration when making hiring decisions.
“Bankruptcy should be your choice only when all else fails,” said Sallavanti. “Your credit score will be dramatically decreased and getting a home, car, or even an apartment to rent will be difficult in the immediate future.”
Do consider alternatives
For those reasons, he said, consumers struggling with debt should first consider alternatives.
That includes credit counseling, debt consolidation, or debt settlement to potentially lower your monthly payments or even eliminate a portion of your debt. (Learn more: What to do when facing a financial emergency)
The United States Trustee Program maintains a list of free credit counseling agencies approved to provide pre-bankruptcy personal finance counseling.
“A little bit of time spent educating yourself about how to rebuild your credit can go a long way,” said Bullock. “Remember that you most likely did not incur all of your debt overnight, so feel free to set short- and medium-term goals for getting your credit health back in check.”
To avoid bankruptcy, some choose debt consolidation, which involves taking out a new personal loan (with a lower interest rate or lower monthly payment) to pay off their existing consumer debts.
Debt settlement is different, as the borrower negotiates with a lender (or more often a collection agency) over a delinquent debt using a third-party debt settlement company or lawyer.
Debt settlement does involve some possible drawbacks: third-party negotiators may charge hefty fees based on the original debt balance, it can take from two to four years to complete, and it will damage your credit score. Typically, debt settlement cannot be used to reduce debt on mortgage, auto, or student loans. (Learn more: Seeking relief when student loans are unaffordable)
“Keep in mind that the IRS may count a debt written off or settled by your creditors as taxable income, meaning you could owe Uncle Sam a check,” said Sallavanti.
Do create a personal balance sheet
If, after careful deliberation, you determine that bankruptcy is still the best course of action, Bullock said you should begin the process by taking stock of your income and expenses, debts, and liabilities.
“So much of bankruptcy from a consumer context is adjusting to the debtor-creditor relationship and learning how to draft a personal balance sheet,” said Bullock. “Making sure you have a complete understanding of who you owe money to is critical.”
Take advantage of free credit reports, which are available once a year through credit agencies Equifax, Experian, and TransUnion and correct any mistakes you find. You can also request a free copy of your credit report from all three credit bureaus at once at annualcreditreport.com.
Do consult a professional
Those experiencing financial hardship often feel overwhelmed and may be more likely to make rash decisions. A financial professional, accountant, or bankruptcy attorney can help take emotion off the table, offering impartial advice and suggestions for the best path forward.
“A good, quality legal professional will do that for you,” said Bullock. “They can help you carefully consider the correct next steps.”
Do be honest
Debtors are required to fully disclose all income and expenses, as well as a complete list of assets and liabilities during bankruptcy proceedings. They are also obligated to be truthful with trustees and creditors.
“Honesty is the only policy when listing your assets and liabilities,” said Bullock. “The right lawyer will be able to tell you what exemptions exist in your state or under the federal bankruptcy law. Even if you find out you can’t keep an asset you had hoped to retain, honesty is always best.”
Do rebuild your credit
Post-bankruptcy, your primary goal is to get your financial house in order. That begins with restoring your credit. (Learn more: Setting financial goals: Using the 5-10-15-20 concept)
Establish a budget, set realistic goals, keep the number of credit cards you have to a minimum, avoid new debt, and most important of all—pay your bills on time. (Learn more: Improving your credit score: It pays off)
Depending on the reason you filed for bankruptcy, a review of your spending and saving habits also may be in order, said Sallavanti. Did you spend beyond your means, get in over your head on credit card debt, or fail to establish an emergency fund to cover unexpected expenses?
“Maybe you had no idea where your money was going,” said Sallavanti. “Creating a budget will help you develop disciplined spending and saving habits. Knowing where your money goes will give you the ability to not only survive but thrive financially.” (Learn more: Don’t have an emergency fund? Get one)
Don’t intentionally incur debt before bankruptcy
If bankruptcy is imminent, it is important that you keep your spending in check.
The government will know if you intentionally ran up your credit card bill prior to filing and it may render you ineligible for bankruptcy protection.
“Don’t incur debt with the intention of not repaying your debt and then file for bankruptcy,” said Bullock. “That is ethically challenged at best, and at worst it could create big problems within the criminal justice system.”
Tax refunds you receive prior to filing for bankruptcy should be discussed with your attorney. Some states provide bankruptcy exemptions for tax credits. Federal bankruptcy exemptions also exist that may protect money you have saved in the bank.
Don’t transfer your assets prior to filing
Those who are bankruptcy-bound must also be careful with the ownership of their assets. Don’t suddenly transfer the title of your car to a friend or family member without disclosing it on your bankruptcy filing.
“That is never a good idea,” said Bullock. “There is a small group of people who think they’ll do better by trying to game the system, but the system is designed to catch that, and it will not permit it. Focus on being honest and it will facilitate an easier entrée into the bankruptcy system and a faster exit.”
Don’t file for bankruptcy while accumulating debt
Timing is everything where bankruptcy is concerned. Remember that there is a limit to how frequently you can file for bankruptcy protection. For example, those who get a Chapter 7 discharge cannot file for bankruptcy again for 8 years.
Thus, you do not want to file if you are still accumulating debt. That includes those who are sick and undergoing treatment and may still be incurring medical bills. In that case, it may be wise to delay a bankruptcy filing until your health is more stable and you can potentially discharge all your debt when your treatment is over.
On the other hand, if your wages are being garnished to repay a debt or a creditor is threatening a lawsuit, it may be in your best interest to file as quickly as possible.
Don’t pay creditors with retirement savings
It’s noble to consider using your retirement savings to pay off as many creditors as you can, but if bankruptcy is a foregone conclusion, you’re better off leaving those funds untouched.
Why? Retirement accounts and pension plans are protected from creditors under both Chapter 7 and Chapter 13 of the federal bankruptcy code and those savings can go a long way in helping to secure your financial security. (Calculator: How much should I save for retirement?)
Bankruptcy is not the end of the financial road. In many cases, it’s a new beginning.
To make the most of a fresh start, however, you must make choices that pave the path to financial wellness. A financial professional can help if you are willing to listen and learn.
“Through the process of filing for bankruptcy, you’ll learn about how credit, assets, and liabilities all work,” said Sallavanti. “Most importantly, you will realize the value of getting serious about your finances: literally and emotionally.”
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