Should I file for bankruptcy?

It's odd how often bankruptcy is misunderstood. Bankruptcy is not necessarily a result of someone being bad with money. Being unable to afford to pay your debts is a situation with many possible causes.  

If you find yourself in the difficult position of deciding whether bankruptcy is right for you, this article may help. In it, we'll discuss how this legal process works, and how it could impact your life. 

Signs it might be time to consider bankruptcy

Because we live in a world where we trade money for the things we need and want, some of our challenges are, naturally, related to finances. When something goes wrong financially, we have options, and bankruptcy is one of them. 

Here's a sample of situations that might lead you to consider bankruptcy:

• Mounting debt: Americans borrow money to buy a home, finance a car, and make everyday purchases. Even one significant crisis could throw off your entire financial equilibrium. If you can't keep up with your debt, much less pay it off, it may be time to learn how bankruptcy works. 

• Missed payments: If you’ve missed one or more payments because you don’t have the money, that’s a red flag.  

• Creditor harassment: Are you nervous about answering your phone or checking your email because bill collectors are hounding you? Bankruptcy puts a halt to creditor harassment and even (temporarily) mortgage foreclosure. 

How does income affect bankruptcy?

Income and related factors affect what type of bankruptcy you may qualify for. There are several types of bankruptcy, although Chapter 7 and Chapter 13 are the most common. Chapter 7 bankruptcy may be the most attractive, because it wipes out most unsecured debts. However, your income, debt level, and household size determine whether you qualify for Chapter 7 or need to file Chapter 13. 

Impact on eligibility

The first thing a bankruptcy attorney or the bankruptcy court will do is a "means test." If you can afford a payment, you won’t qualify for Chapter 7. Instead, you’ll be directed to Chapter 13, which is a three or five year repayment plan. 

To determine your income, the court looks back at all your sources of income over the past six months. This includes wages, tips, bonuses, retirement benefits, unemployment compensation, rental income, and money gifted from other people. If you're married but your spouse is not claiming bankruptcy with you, their income is considered.

Your income is compared to the median income in your state for a household of similar size. If your income falls below the state median, you typically qualify for Chapter 7. However, if your income exceeds the state median, the test continues. 

Evaluating income vs. expenses

Your level of disposable income is calculated. In other words, the court wants to know how much you have left over each month after paying necessary expenses like rent or mortgage, transportation, utilities, healthcare, and other costs. 

The size of your household is also taken into account. The larger the household, the higher the allowable income threshold for Chapter 7. Household size includes your children and others who live with you and rely on your financial support. 

Finally, your level of debt comes into play. Suppose you live in a high-cost-of-living area, and your debt load is substantial. In that case, the means test may show that you don't have enough disposable income to repay your creditors, making you eligible for Chapter 7. 

Steady vs. irregular income

If your salary consists mainly of commission, you work a seasonal job, or you have fluctuating income for any other reason, the means test can be more complicated. You'll want an attorney to walk you through this step carefully. Your attorney is likely to request detailed income documentation before deciding which type of bankruptcy the court is likely to approve. 

What happens to assets in bankruptcy?

It's natural to wonder if the bankruptcy court will take possession of your car, home, boat, ATV, or other asset. The answer is "maybe." It depends on whether you file Chapter 7 or Chapter 13. 

While Chapter 13 involves setting up a repayment plan for your creditors, Chapter 7 does not. Instead, the bankruptcy trustee gathers and sells your nonexempt assets and uses that money to repay creditors. Here are some examples of assets considered exempt (assets that the court won't typically take):

• Your vehicle, up to a specific value

• Reasonably necessary clothing

• Reasonably necessary household goods, appliances, and furnishings

• Your retirement account

• Your life insurance policy

• Your pension

• Alimony and child support 

• Jewelry, up to a specific value

• A portion of the equity in your home

• Public assistance, Social Security, and unemployment compensation

• Damages you've been awarded for personal injury

• Tools of your trade or profession, up to a specific value

And here's a sample of non-exempt assets. These are items the court will likely liquidate (sell) to help repay your creditors:

• Cash, bank accounts, stocks, bonds, and other investments

• A second car or truck

• A second home or vacation home

• Stamp and coin collections

• Expensive musical instruments, unless you're a professional musician

How to protect your assets before filing for bankruptcy

Before you do anything to protect your assets, speak with a bankruptcy attorney. Here's why:

• Your state has its own list of exempted assets, and it may be in your best interest to take advantage of those exemptions. 

• An attorney can advise you on other issues, such as whether there are any tools available to you to help you protect assets. 

• An attorney can help you avoid making mistakes bankruptcy courts do not look upon kindly.

• When it's time to file, an attorney will help you cross all your Ts. For example, you'll have the opportunity to list the assets you'd like to keep. An experienced bankruptcy attorney can walk you through the process and offer a realistic idea of what to expect.

Chapter 13 monthly payments explained

Chapter 13 bankruptcy is sometimes called a "consolidation plan" or "debt reorganization plan." It's designed primarily for those with a steady income and the ability to repay (at least some) of their debt. With Chapter 13, you don't have to worry about which of your assets are exempt and which are non-exempt, because you're entering a payment plan with your creditors. 

The main distinction is that the payment plan is based on your income, not on the size of the debt.

The repayment process begins when your attorney and the bankruptcy court evaluate your debt and divide it into categories. Depending on their category, the debts are either prioritized for repayment or forgiven. 

• Priority debt: Items that must be paid off first. Examples include spousal support, child support, back taxes, bankruptcy filing fees, and any court fees you've incurred. 

• Secured debt: Debts backed by collateral—like mortgages and auto loans—are secured debts, and you may be required to pay them in full (if you don’t want to give up the collateral). 

• Unsecured debt: The court considers these lowest priority. They include credit card bills, unsecured personal loans, and medical bills. These debts receive the smallest portion of your monthly payment. It's also possible they'll be discharged or reduced. 

Once the court has approved your bankruptcy petition, you work with your attorney to create a repayment plan and your attorney files it with the courts. The court will require that you pay all of your disposable income into your plan. Once the court accepts the proposed payment plan, a trustee is named to oversee repayment. You make a single payment to the trustee each month. In turn, the trustee sends a payment to each creditor. Payments are typically made monthly or bi-monthly, with your first payment due within 30 days. 

If your creditors aren’t fully paid off by the time your plan ends, the remaining debt is discharged (forgiven). If you qualify as low-income, your payment plan will last three years. Otherwise, you’ll pay for five years.

About half of Chapter 13 cases fail, often because the payment is too high to maintain.

Alternatives to bankruptcy

While bankruptcy is an option, it might not be your only option. Here are several others:

Debt settlement

Also known as debt relief, debt settlement is a way to clear your debt for less than you owe. It involves negotiating with your unsecured creditors to reduce the amount you owe and forgive the rest. Debt settlement is private (bankruptcy is public record). 

You do have to set aside money every month for the purpose of negotiating your debts (or to make payments). But the amount can be affordable. A judge doesn’t have to approve it.

Debt consolidation

With debt consolidation, you take out a personal loan and use the funds to pay off multiple debts. Ideally, the interest rate on the personal loan is lower than the rate you're paying on existing debt. Once old creditors have been paid, you make a single monthly loan payment. 

Debt consolidation is for people who can afford to fully repay their debts, but who could benefit from streamlining them. Also, you’ll need to have a good enough credit standing to qualify for the new loan.

Credit counseling

Sometimes called debt counseling, credit counseling matches you with a debt counselor who can help you create a budget and plan for your future. If you can afford to repay your debts but you need help managing them, the counselor might suggest a debt mangement plan. You’ll make one payment to the counseling agency and they will distribute it to your unsecured creditors. The counselor might be able get some fees waived or interest rates lowered, but you’ll repay your debts in full. 

You’ll typically have to agree to close your credit card accounts while you’re in the plan.

Examples of when to consider bankruptcy 

The decision to file for bankruptcy is highly personal. However, if you're thinking about it, here's how to know it might make sense. 

Chapter 7

• You have unsecured debts with high balances.

• You have few assets.

• You can pass the bankruptcy court's means test.

For example, if you're recently divorced, carry credit card debt, don't own a home, and don't drive a flashy car, Chapter 7 could be a good fit for you. 

Chapter 13

• Your mortgage lender has started foreclosure, and you don't want to lose your home.

• You earn enough money to enter into a repayment plan.

For example, if you work a steady job but a hardship—like an outrageous medical bill you're afraid you'll never pay off—has thrown you into financial instability, you may want to consider bankruptcy.

When debt settlement is more appropriate

• You don't want the public record of bankruptcy showing up on your credit report for 7 to 10 years. 

• You're experiencing financial hardship that leaves you unable to fully repay your debts.

• You make too much to qualify for Chapter 7.

• You have assets that aren’t exempt in your state, and you don’t want to lose them in a bankruptcy.

Most people hit financial roadblocks in life, and sometimes those roadblocks feel more like mountains to climb. Whatever decision you make, there is zero shame. Life happens, and financial issues can get the best of anyone. 

The goal is to do something that will relieve the financial burden and let you keep enjoying life.