Declaring bankruptcy is a pretty extreme measure. But used in the right way at the right time, it can save you money, preserve your peace of mind, and get you back on your feet financially.
However, declaring bankruptcy can also be expensive and time-consuming and have a huge impact on your credit score. This, in turn, can have far-ranging effects on other aspects of your life, such as buying a new car or home or even applying for jobs. Also, waiting to declare bankruptcy until you’re completely broke can actually work against you.
If you’re contemplating declaring bankruptcy, here’s what you need to know.
Consider Alternatives to Bankruptcy
Because declaring bankruptcy has significant and long-ranging effects, consider all possible alternatives first. Ask yourself the following question. If you answer yes to any of them, bankruptcy might not be the right choice just yet.
Can You Find the Money to Pay Bills Another Way?
Brainstorm ways you can make some extra cash. Taking on a second or third job isn’t a fun way to spend your evenings and weekends. But even if it’s just for a short period of time, the extra income could put a real dent in your debt.
Have You Been Following a Budget?
Many people don’t follow a budget and thus don’t really know where their money goes. Without good budgeting, such as using a budget program like Mint or a cash-only envelope budgeting method, it’s hard to see where or how you can make changes that will free up your money.
For most of us, the largest chunks of our income go to housing and transportation costs. So consider ways to cut these costs. For example, if you’re a renter, downsizing your home and moving to a smaller place or looking for a roommate could have a big impact on your rent cost – and you might save on utilities as well. If your car is a gas guzzler, selling it and buying a small, fuel-efficient car could save a lot of money you can instead use for paying off debt.
Is Your Situation Temporary?
Realistically consider whether or not your financial problems are temporary. For instance, if you’ve lost your job, will you qualify for unemployment benefits? How good are your prospects for getting another job?
When you file for bankruptcy, the court looks not only at your current income but also at your income over the past six months or more. If you’re currently having a financial problem, but you’ve historically paid your bills on time, consider waiting a few months to see if you can improve your situation.
Can You Negotiate Directly With Your Lenders?
Many lenders will lower interest rates or adjust your payment plan if you tell them you’re considering bankruptcy. That’s especially true of credit card companies, which stand to lose the most if you can’t pay them back. In some cases, you may qualify for a low fixed interest rate but will need to close the card.
If you have student loans, which can’t be wiped out in bankruptcy, you may qualify for hardship programs, which lower monthly payments by changing your repayment schedule or tying payments to your income level. Alternatively, you may qualify for deferment or forbearance on your student loans, which temporarily suspend payments.
Some mortgage lenders offer loan modification programs. Call your lender to see if they have a program you qualify for before you declare bankruptcy – most lenders are not willing to negotiate afterward. If your mortgage is modified sufficiently, you may avoid bankruptcy, which is beneficial for both you and the lender.
Have You Attended Credit Counseling?
Another good idea is to go to consumer credit counseling. These agencies can help you negotiate with your lenders, which can be stressful and ineffective on your own, especially if you don’t handle confrontation well. They’ll also help you create a realistic budget and debt pay-down plan and advise you on whether or not to pursue bankruptcy.
Be careful who you go with, though. There are a lot of predatory companies that will take your money without actually helping you. Most reputable agencies are low-cost, and no legitimate agency will promise to wipe out your debts or get your debts forgiven for pennies on the dollar. If someone promises that, run in the other direction. Check this list of approved agencies from the Department of Justice.
Will Bankruptcy Actually Benefit You?
Qualifying for bankruptcy is a pretty stringent process. If you have a regular income, you may be required to file Chapter 13 bankruptcy, in which you set up a payment plan over three or five years. You’ll use most of your disposable income to pay debts, and the court is very strict on what it considers disposable income. It will allot you money for necessities like food, clothing, transportation, medical expenses, and utilities and allow you to pay secured debts like your car loan or mortgage in full. All your other money will be sent to your creditors.
It makes sense to figure out a debt payment schedule before pursuing this option. For example, say you bring home $2,000 per month, have a $1,000 mortgage, and are allowed $400 in other living expenses. That leaves you $600 per month to pay off debts. If you’re on the three-year plan, you could pay $21,600 in debt. If you’re on the five-year plan, you could pay $36,000 in debt. If you have significantly less debt than either number, you probably won’t benefit from bankruptcy. In this case, negotiating with your lenders directly could achieve the same or better results.
Consider a Short Delay
Sometimes, it can be beneficial to wait before actually declaring bankruptcy. For example, you may be able to declare Chapter 7 instead of Chapter 13 bankruptcy, avoid losing valuable assets, or keep from going straight back into debt again by waiting a relatively short period of time before filing.
If any of the following situations have occurred within the last several months, waiting even a few months can help you get the most out of the bankruptcy process.
You Recently Had a High Income
When you file for bankruptcy, the court looks at your monthly income. However, it determines that monthly income by averaging it over the past six months. It then subjects that average monthly income to the means test, an examination that prevents individuals with a higher-than-average income from using Chapter 7 bankruptcy.
If you’re considering filing Chapter 7 bankruptcy, but you recently had a high income from a job you lost, it may be prudent to wait a few months until your six-month average income decreases. Otherwise, you may not pass the means test and your only option will be to file Chapter 13.
You Can Sell Your Assets Yourself
If you file Chapter 7 bankruptcy, the court will take your non-exempt assets, such as stocks and bonds or an expensive car, and sell them to pay your creditors. If you have such items, you’ll probably get more money if you sell them yourself.
For example, you’ll likely get more selling your car on Craigslist than you would if the car is auctioned off. You’ll be able to pay down more of your debt than the court would, or you can spend the money on reasonably priced exempt assets the court won’t take, such as a less expensive car.
Don’t attempt to hide any money, though, or you’ll end up in serious hot water. You’ll also get in trouble for giving assets away the court could have sold. Make sure you get a fair price for assets and don’t sell to relatives. The court can take back an item you sold and sell it itself if it thinks you were trying to do something shady.
You Expect a Large New Debt Soon
Once you submit your bankruptcy petition, you won’t be able to add to the list of debts you’re having modified or discharged. So if you expect a large, unavoidable expense in your future, consider waiting until after you incur it to declare bankruptcy.
For example, if you’re pregnant and will incur medical bills for the delivery, wait until after you have your baby and receive the bills to declare bankruptcy. This way, you can include those bills on your bankruptcy petition. Otherwise, if you declare bankruptcy before having the baby, you’ll still be responsible for paying the medical bills and may go further into debt.
You must be very careful when incurring any new debt close to the date you declare bankruptcy, however. If the trustee or judge finds you purchased luxury goods, took out cash advances, or otherwise spent a lot on unnecessary items, it will consider that a sign you acted irresponsibly. Those debts may “survive” the bankruptcy, and you’ll still have to pay them even if the rest of your debts are wiped out.
Bad Reasons to Declare Bankruptcy
In certain cases, there are other ways to deal with falling behind on unsecured debt or receiving unwanted collection calls. Also, bankruptcy will not provide a reprieve for certain kinds of debt.
Here are some instances in which declaring bankruptcy is a bad idea.
1. You Can’t Make Payments on Small Amounts of Unsecured Debt
Unsecured debt, which includes most credit cards and medical bills, is debt the lender allowed you to run up without asking for collateral in return. Therefore, if you default on unsecured debt, the lender doesn’t have anything to repossess.
A lot of people think that not making their payments on these debts will have significant consequences like wage garnishment, but most unsecured lenders aren’t able to take these extreme measures without actually suing you in court. If you do get sued, simply filing a response asking the lender to prove they own the debt and that you owe them can delay things for months.
If you completely stop paying, especially if the debt is small, lenders may write it off as uncollectable or be willing to accept a lump sum for a portion of the debt’s worth. Negotiating your interest rate or payment terms can work very well with unsecured debt. As long as your creditors think you’re likely to declare bankruptcy, they’re usually happy to negotiate with you because they know they’ll get little, if anything at all, from bankruptcy proceedings.
2. You Just Want to Stop Collection Agents From Calling You
There ‘ a simpler way to do this. It’s called the Fair Debt Collection Practices Act (FDCPA). The FDCPA requires that collectors stop calling you if you ask them to. They’re also not permitted to call people who know you or contact you at work if you ask them to stop.
Simply send the company a certified letter requesting this. After that, no agency employee is permitted to contact you except to let you know they’re going to sue you or are stopping collection efforts. Suing collectors who violate the FDCPA is a popular and lucrative practice.
Recording your calls and saving your voicemails is an effective way to prove collectors are continuing to call you even after you asked them to stop. The FDCPA does not apply to your original lender, however, since they have a “business relationship” with you and are permitted contact. Usually, the original lender is not nearly as annoying as a collections agency, though.
3. Most of Your debts Are From Recent Income Taxes, Court Judgments, Child Support, or Student Loans
Bankruptcy treats different kinds of debts differently. Income taxes, court judgments, child support, and student loans are some examples of debts that can’t be erased in bankruptcy in all but the most extreme cases. If a large proportion of what you owe is made up of these debts, bankruptcy will probably not be advantageous for you.
4. You Don’t Have Any Assets or an Income Outside of Social Security, Unemployment, or Welfare
Except for certain debts like intentionally unpaid taxes, back child support, or government-guaranteed student loans, creditors can’t touch Social Security income, unemployment, or welfare. Even if they sue you, they can’t take your money if you don’t have any.
Filing bankruptcy in this case would be redundant. If you don’t have income creditors can garnish, assets they can seize, or property they can put a lien on, there isn’t much they can do to you other than annoy you with phone calls.
When to Move Forward With Bankruptcy
If none of the above situations apply to you, bankruptcy may be a viable option. And if your debt is spiraling out of control, don’t wait too long to declare it.
Below are a few “red flags” that can indicate your current financial situation is untenable. In these cases, bankruptcy may offer the only way out.
1. You’re Putting Everyday Necessities onto Credit Cards
Consistently putting groceries or gas on a credit card because you have no available cash is a big red flag that you’re on a treadmill of debt. Most people do this because they spend their entire paycheck on debt payments.
This cycle makes your situation worse. You spend $100 on your minimum payment, but you need $100 in groceries, so you charge it to the card you just paid. Your total debt actually goes up from this money trade because of interest.
2. You’re Paying One Credit Card With Another
Paying one credit card by taking out a cash advance or transferring the balance to another card is just a stalling tactic and doesn’t make your debt go down. If it’s a one-time thing, it’s not necessarily a red flag, just a sign of a temporary crunch. But if it happens regularly, your debt will go up stratospherically.
3. Your Interest Rates Have Already Gone Up Due to Missed Payments
It’s hard enough to dig yourself out of debt when it’s at a reasonable interest rate. But if you’ve missed a payment or two, many lenders, especially credit card companies, will jack up your interest rate to 30% or more. Once the rate is that high, most of your payment each month is going toward interest, and very little goes toward principal.
The interest rate hike also increases your monthly payment, which you may already have a hard time paying. If you have unpayable debt at high interest rates, and you aren’t able to negotiate lower rates with the lender, bankruptcy may be a viable option.
4. You’re Already Working a Second or Third Job
For many people, earning an extra income is enough to diminish their debt – but not always. If taking on a second or third job helps pay your monthly bills, that’s a great start. But if your debt is already so large that an extra 10 hours of work per week isn’t denting it, you may need to consider more extreme measures, such as bankruptcy.
5. Your Wages Are Going to Be Garnished
In extreme cases, a lender can get a court order to garnish your wages. That means they make an arrangement with your bank or employer to take money directly out of your paycheck. Your wages can only be garnished if you take home at least 40 times the minimum wage each week – the equivalent of working full time at minimum wage. But since that’s not much money to begin with, most people develop additional financial problems if a lender garnishes their wages and wind up increasing their debt with other lenders.
If you’ve received notice that a lender is attempting to garnish your wages, declaring bankruptcy will prevent this order from going forward, at least temporarily. Plus, you may be able to have the debt dismissed.
6. Debt-Related Stress Is Affecting Your Work and Personal Life
It won’t help your financial situation if you’re so worried over debt that you can’t focus at work and get fired. If debt problems are interfering with your life to a significant extent, declaring bankruptcy might go a long way toward improving it.
7. You’re Considering Taking Money From Retirement Accounts to Pay Debt (or You Already Have)
Retirement funds are money for your future. If you pull that money out, you’re not only robbing your future self but also creating a tax bill that might become one more debt you can’t pay. Since many retirement accounts are protected in bankruptcy, avoid pulling any money out if you’re considering declaring it.
8. You’ve Already Tried the Alternatives, and They Didn’t Help
If, despite all your best efforts, you’re not making a sufficient dent in your debt, it may be time to petition for bankruptcy.
Declare Bankruptcy While You Still Have Cash
Many people think the point at which they should declare bankruptcy is when they’re broke. But being penniless will actually make the process that much harder. While you can certainly declare bankruptcy on your own, many people choose to hire a bankruptcy attorney, which can cost between $1,000 and $2,500, even for a simple case.
If you’re certain you’re heading toward bankruptcy, it can be a smart move to stop certain paying bills, like credit cards that may be discharged anyway, and save your cash for an attorney. Not surprisingly, bankruptcy attorneys don’t take credit cards. That said, keep paying your mortgage or car loan, since you’ll have to make up those missed payments plus fees if you want to keep the car or home.
Also, once you declare bankruptcy, your creditors will be notified and will probably reduce your available credit or otherwise limit you from further credit card use. If you’ve been living entirely on credit, you’ll need to have cash on hand for living expenses after submitting your bankruptcy petition.
Declaring bankruptcy is a huge financial step, but if a string of problems has left you mired in debt, it may be the right step to get you back on track. However, if you use bankruptcy inappropriately, you could end up in a worse financial situation than if you had tried to solve your problems through less extreme measures.
Bottom line: Consider and pursue all bankruptcy alternatives first. Then, if you do decide to declare bankruptcy, time it correctly to get the most debt wiped out via the process.
Have you ever filed for bankruptcy? When and why did you do it?