Pros and Cons of Filing Bankruptcy
Bankruptcy is a legal process that might get some or all of your debts discharged (or forgiven). One out of 10 Americans ends up filing for bankruptcy at some point during their lifetime. Bankruptcy isn’t anyone’s end goal, but it’s not something to feel ashamed about, either.
While bankruptcy can be a liferaft if you’re drowning in debt, it’ll affect your credit history for seven to 10 years. Learn the pros and cons of filing for bankruptcy before deciding if this path is right for you.
What happens when you file for bankruptcy?
There are a lot of misconceptions when it comes to bankruptcy. Some assume they’ll lose everything they own after filing or never be eligible for credit again. This is not true.
Depending on the type of bankruptcy you file, you may be able to keep many — if not all — of your assets. Personal loans after bankruptcy and car loans after bankruptcy are still possible too.
Bankruptcy doesn’t necessarily mean you have a spending problem, either. In fact, medical bills are one of the leading causes of bankruptcy in the United States.
While there are six types of bankruptcies, most people file Chapter 7 or Chapter 13.
Chapter 7: Under Chapter 7 bankruptcy, all of your eligible debt will be discharged, but you may have to sell assets. Most filers qualify for a “no-asset case,” which means they won’t have to sell anything. Chapter 7 typically shows on your credit report for 10 years.
Chapter 13: Chapter 13 bankruptcy does not require you to sell assets. Instead, you’ll have to use your disposable income to pay off some or all of your debt in three to five years. Chapter 13 typically shows on your credit report for seven years.
The pros of filing for bankruptcy
If you’re overwhelmed with debt and have no way out, bankruptcy can give you a fresh start. Here’s how bankruptcy could be beneficial.
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Will stop most debt lawsuits, collections calls and wage garnishments
When you file for bankruptcy, you’ll get an automatic stay. An automatic stay will stop most lawsuits if you’re being sued by debt collectors. Debt collectors must also stop calling, and wage garnishments will end.
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You will get help from a court-appointed representative
Even if you file bankruptcy without a lawyer, you won’t handle everything yourself. Instead, the court will assign you a trustee.
The trustee will handle all communication from your creditors, taking some stress off your shoulders.
The trustee will also sell your eligible assets on your behalf (or file no-asset paperwork with the court) if you file Chapter 7. Under Chapter 13, the trustee will collect your payments and send them to your creditors.
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You may no longer be legally responsible for your debt
You are not liable for discharged debt, and debtors must stop hassling you about it in the future. This only applies to eligible debt. Certain debts, such as back child support, cannot be discharged.
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Can help eliminate the hassle of dealing with multiple creditors
Chapter 13 consolidates your debt. Instead of owing money to several lenders, you’ll have one bill to pay — your bankruptcy repayment installment. Bankruptcy repayment installments are typically due biweekly or monthly.
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You might not need to sell assets
With Chapter 13, you won’t sell your assets to repay your debt. Instead, you’ll pay it over time under a payment plan.
Chapter 7 requires you to sell assets, but not all assets are eligible. Everyday items like your clothes and car (depending on its value) are exempt from bankruptcy. Most Chapter 7 bankruptcies are no-asset cases, where the filer has nothing eligible to sell.
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Wipes out eligible back taxes
Filing for bankruptcy can help you address those back taxes you’ve been worried about. Back taxes that are older than three years can be discharged after Chapter 7 and Chapter 13 bankruptcy.
You must have filed corresponding returns on time for this to apply. Also, only income taxes are eligible. Fraud penalties and payroll taxes are never discharged.
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You can save your home from foreclosure and your car from repossession
You can use Chapter 13 to stop home foreclosure, even if the foreclosure is currently in process. You’ll still have to make your mortgage payments, but you’ll get three to five years to catch up.
Chapter 13 also protects your car from repossession. You still have to pay your car loan, but you’ll have more time to do so, since the debt will be worked into your repayment plan.
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Your debt may be settled for less than you owe
If you have a no-asset Chapter 7 case, your unsecured debt will be discharged even if the creditor didn’t get paid. This includes debt due to personal loans, medical bills and credit cards. If you have assets to sell, whatever you get will be applied to your debt. Any eligible debt that is left over will be discharged.
With Chapter 13, you’ll have to pay your creditors, but you might not have to pay back your debt in full. If you have any debt leftover after your repayment plan, it may be discharged.
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If you have bad credit, bankruptcy might improve your credit score
According to a LendingTree study, people with credit scores under 580 saw dramatic increases in their credit scores one month after filing for bankruptcy — around 90 points, on average. Those with scores between 580 and 619 saw more modest bumps of about 13 points.
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Can get new credit once your debts are discharged
Once your bankruptcy case is closed and your debt is discharged, you are free to apply for new credit.
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Wipes the slate clean
Life after bankruptcy can seem scary, but this might just be the fresh start you need. You may have an easier time changing your spending habits and budgeting for the future when you’re no longer under crushing debt.
The cons of filing for bankruptcy
If bankruptcy didn’t have negative consequences, then everyone would file for it. Learn what’s at stake before taking such a drastic step.
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You could lose your home under Chapter 7
Your trustee might choose to sell your house if you have a lot of home equity. Many other factors come into play though, such as your state’s homestead exemptions and how long you’ve owned your home.
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Bankruptcy can wreak havoc on your credit score
Filing for bankruptcy can improve your credit score if it’s already tanked. But if you have good credit, prepare for a huge drop.
In our previously mentioned LendingTree study, we found that those with scores from 660 to 719 had an average decrease of about 36 points. And scores for bankruptcy filers with excellent credit (720+) saw an 83-point drop.
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Bankruptcy isn’t free
Between lawyer fees, court costs and filing fees, bankruptcy isn’t cheap. Chapter 7 typically costs between $1,000 and $1,750. Attorney costs alone for Chapter 13 generally range between $2,500 and $5,000.
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Bankruptcy won’t discharge your federal student loans (in most cases)
The government has relaxed the rules around bankruptcy and student loans in recent years. Still, getting your federal student loans discharged through bankruptcy is a tall task.
You must file something called an adversary proceeding and prove to the court that paying back your loans would cause undue hardship. The court gets to decide what an undue hardship is.
If you’re struggling to pay your federal student loans, it may be worth exploring forbearance, deferment or an income-driven repayment plan.
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You may still have to pay off some of your debt
Not all debts are eligible for discharge. Some common debts you must always pay back include child support, alimony and personal injury debts you accrued as a result of drunk driving.
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Cosigners may still be responsible
Your cosigner may still have to pay the debt, even if you file for bankruptcy. Chapter 13 protects cosigners for consumer debt, like credit card bills. Chapter 7 doesn’t.
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You could face criminal charges if you aren’t honest
Lying or knowingly misrepresenting your financial situation is bankruptcy fraud. If convicted, you could spend up to five years behind bars, be charged a fine of up to $250,000 or both.
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Bankruptcy can take a long time
Chapter 7 bankruptcy usually takes between three and four months, so it’s a fairly quick process. Chapter 13, on the other hand, requires a three- to five-year repayment plan.
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You could lose your business
Unless you’re eligible for an exemption, you could lose your business through Chapter 7 — but not always.
Whether or not you’re a sole proprietor and what kind of business you have (service-oriented versus product-oriented) are also other factors. Plus, your trustee probably won’t sell your business if it isn’t (very) profitable.
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You might be evicted if you’re behind on rent
Your landlord can’t evict you for filing for bankruptcy. That is, as long as you’re current on your rent (assuming you aren’t breaking any other terms of your lease).
If you are behind and you’re filing Chapter 7, you could keep your place as long as you pay your future rent payments on time. You must also get caught up on your past due payments within 60 days.
For Chapter 13, you need to work both your current and past due balances into your payment plan.
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It will be hard for you to rent a new apartment or house
Some property management companies and private landlords automatically reject applicants with past bankruptcies. You’ll find it even more difficult to rent if the bankruptcy leads to an eviction. You might want to wait to file until you know you’re staying put for the next couple of years.
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Bankruptcy could affect your career
Bankruptcy shouldn’t affect your current job. Employers can’t fire you because you filed, and they can’t demote you for it, either. However, bankruptcy can impact future employment.
Many employers run a credit check on their applicants. Employers can’t see your credit score, but they can see if you’ve filed and how many late payments you’ve made. If you’re applying for a job in the private sector, the employer can use your bankruptcy against you.
Thankfully, past bankruptcies only affect your chances of being hired if you work in a money-related field. Payroll, for instance.
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Bankruptcy filings are public information
When you file for bankruptcy, it is published as public record. People can see if you’ve filed by using an online search tool called PACER, or Public Access to Court Electronic Records.
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You might not qualify for new credit card or loan
You might find it hard to get new credit when you have a bankruptcy on your credit report. The lenders that are willing may only offer you a secured card. These require a deposit.
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Borrowing will be expensive for a while
When you do qualify, prepare for high interest rates and loan amounts. Immediately after you file (or ideally, before), it’s time to rebuild your credit. This can help you nab lower rates when you’re ready to borrow again.
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You can’t buy a home right away
To get a mortgage after bankruptcy, you must go through a waiting period first. For conventional loans, you’ll have to wait four years after your Chapter 7 filing to apply. Chapter 13 has a waiting period of two years after discharge.
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Your car insurance premium will probably go up
In most states, car insurance companies can use your credit-based insurance score to calculate your premium. Your credit-based insurance score and your regular credit score aren’t the same things. Even so, past bankruptcies negatively impact both.
Maryland, Michigan, Oregon and Utah allow car insurance companies to use credit-based insurance scores but have rules about how and when these scores can be used.
In all other states, your credit score will typically impact your car insurance premium.
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Bankruptcy won’t change your spending habits
Bankruptcy might be a temporary band-aid. If you don’t change your spending habits, you may have to file bankruptcy a second time.
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It’s not easy to cancel your bankruptcy after you file (and in some cases, it’s impossible)
The court must grant you a dismissal if you want to cancel your bankruptcy after you file (but before discharge).
Chapter 7 cases that involve assets are generally harder to get dismissed. Judges often decline these dismissal requests to stop people from backing out because they don’t want to sell property.
Chapter 13 cases are a little easier to get dismissed, but you’ll lose your automatic stay. Once dismissed, creditors can restart their collections process. They can also backdate late payment fees from the day the automatic stay was put into place.
Bankruptcy alternatives
Debt consolidation
Debt consolidation doesn’t reduce your debt, it reorganizes it. You’ll take out a debt consolidation loan and use it to pay your multiple creditors. After, you’ll only have one monthly loan payment to make. Debt consolidation loans usually come with lower rates than cards if you have good credit.
Debt consolidation makes the most sense if you are juggling multiple debt bills, qualify for a better rate than what you have now and can pay your debt in full.
Debt management plan
You’re required to go through credit counseling when you file for bankruptcy. Here, a credit counselor will review your finances and help you create a budget. Your counselor might find that you’re a good candidate for a debt management plan during the process.
Like Chapter 13, a debt management plan will help you pay off what you owe in three to five years. Your credit counselor may also be able to negotiate with your creditors to get fees waived or your rates reduced.
A debt management plan makes the most sense if you’re overwhelmed by debt but you want to avoid bankruptcy.
Debt settlement
Debt settlement is a risky type of debt relief. You’ll work with a third-party company that will attempt to negotiate with your creditors. The end goal is to pay less than what you owe.
However, there’s no guarantee that your creditors will be willing to negotiate. If they aren’t, you’re still on the hook to pay the debt settlement company. Also, you will likely stop paying your debts as the company negotiates. This can ruin your credit score.
Debt settlement can make sense if you already have bad credit and have debt you can’t pay back. Still, know the risks before pursuing this option.
Frequently asked questions
That said, there are state and federal exemptions that can help you protect your property. Chapter 7 allows you to keep items of daily living, like your clothes, work tools, Social Security benefits and, in many cases, your primary car.
One benefit of Chapter 13 is that it protects your assets as long as you repay at least some of your debt
We strongly encourage you to speak with a bankruptcy attorney before filing.
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