Is Bankruptcy the right choice for you?

Bankruptcy is a federal court process that helps individuals and businesses repay their debts under the protection of the bankruptcy court or wipe their debts out altogether.

Until October 2005, many people were granted a chapter 7 bankruptcy which wiped out all debts. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made major changes to bankruptcy law, making it much more difficult for some people to erase debts by filing for bankruptcy. The net result of this is that most people who file bankruptcy end up with a chapter 13, which means they have years of repayment and many more years of serious credit damage.

There are two basic types of bankruptcies that apply to most individuals: reorganization (Chapter 13) or liquidation (Chapter 7).

Chapter 13

In a Chapter 13 bankruptcy, you are required to file a repayment proposal with the bankruptcy court. Some debts must be repaid in full, some are partially repaid as a percentage of the original debt, and others aren’t repaid at all. In general, you will be required to repay as much as possible, and virtually all of any secured debts such as mortgages or car loans, and all student loans. Payment plans are typically over a five year period. During this repayment period, the court will place restrictions on how you are allowed to spend your own money. You are likely to have your wages garnished (a portion taken out of your paycheck prior to your receiving it) from which payments are made on your behalf by the trustee.

Chapter 13 may be the right choice for

  • people who do not care about their credit (i.e. have no intention of buying a house or car for the next 12 years)
  • cannot afford to repay at least 60% of their debt as determined by court auditor reviewing your budget for any discretionary spending
  • will not mind having the court dictate how you can spend your money for the next 5 years
  • can afford the legal fees required to file bankruptcy ($1200 to $5,000 with $2,500 as an average).

Chapter 7

In a Chapter 7 bankruptcy, you will turn your personal property (with some exceptions like “reasonable transportation”) over to the court, which will sell it via bankruptcy auction and use the proceeds to pay all or a portion of your debts. For those seeking a fresh start, have little or no assets, absolutely cannot afford even a partial repayment of their current debts and have no degree or history of employment by which the court will believe your income sufficient to support a chapter 13 repayment plan, but can afford the legal fees to file bankruptcy ($2500 average), chapter 7 bankruptcy may be the right choice. Be advised that credit damage will last for 7 years after filing, and all purchases prior to the bankruptcy will be reviewed and may be thrown out. Also, due to the October 2005 legal changes, most chapter 7 bankruptcies are changed to chapter 13 repayment plans.

In order to file for Chapter 7, your income must be below the median income for similar sized families within your state or you’ll be required to go through a bankruptcy “means test” by which the court will review your income history for potential earnings. For those with a recent job loss or declining income, the court may look back further. Once you pass the “means test”, the court will review your spending patterns. If the court believes that you have $100 or more per month in disposable income that you could apply towards your debt repayment after allowances for child support, food, housing, and other related expenses, you’ll be refiled into a chapter 13 repayment plan.

Bankruptcy is a combination of state and federal law, and each state varies. If you have lived for less than 2 years in your current state of residence, you may be required to file in your previous state. This portion of the law was pushed through by creditors seeking to avoid people moving to a state favorable for bankruptcy as a means to escape their debts.

Mandatory Credit Counseling

New bankruptcy law requires that anyone who files bankruptcy must received credit counseling and a financial education program as a condition for filing bankruptcy and discharging debts. No one can file bankruptcy unless they complete a state accredited credit counseling program within 180 days of their bankruptcy filings.

Increased Paperwork and Higher Legal Costs

If you wish to file for bankruptcy, you will need

  • Complete schedules of all assets and liabilities.
  • Complete schedules of all income and expenses.
  • A list of all creditors, secured and unsecured.
  • Certificate of credit counseling.
  • Evidence of payment from employers, including pay stubs of the past 60 days.
  • Statement of monthly net income.
  • The court may review your credit card statements and/or bank statements for purchases made within the last 90 days prior to filing, or as far back as one year for larger purchases. Cash withdrawals can be thrown out of the case or result in case dismissal.
  • Tax returns for the most-recent tax year.
  • Tax returns for several years prior to the filing, if those returns hadn’t previously been filed with the IRS.
  • & more.

If these documents aren’t provided to the court within 45 days of initial filing, the court will automatically dismiss the case. Extensions beyond 45 days are up to the court. Legal costs under these new requirements are estimated to much higher than what layers charged under the old law, so the above cost estimates may be outdated. Bankruptcy attorneys are also required to certify their clients’ claims for their assets, liabilities, income and expenses, and could face court sanctions if they are not.

Bankruptcy is public record and therefore public information for life. Bankruptcy can complicate or prevent your obtaining certain professional licensing for life, and can complicate or prevent obtaining certain types of financing for life, such as certain SBA business financing or home construction loans. Bankruptcy will stay on your credit report from 7 years of dismissal (12 years total for chapter 13), and will result in higher rental rates and/or larger deposits, denial or higher rates for home loans, higher insurance rates in most states, and other problems associated with bad credit. Also, having your debts erased does not solve endemic financial problems; if your spending exceeds your income you will continue to be in your present situation.