What Are the Signs I Should File for Bankruptcy?

In many ways, filing for bankruptcy is like saying, "I need a realistic way of dealing with my current financial situation." Rather than the "boogeyman" of personal finances, bankruptcy represents the first step on a new, better road for many. 

If you're facing debt, you owe it to yourself to learn more about how bankruptcy works, how it could impact your future, and alternatives to bankruptcy worth considering. 

Freedom Debt Relief can’t advise you on your specific situation and whether bankruptcy is appropriate. If you want to learn more about bankruptcy and whether it’s a path you want to take, make an appointment to talk to a bankruptcy lawyer licensed to practice in your state. Many offer an initial consultation for free.

What Is Bankruptcy? 

If you're unable to repay your debts, bankruptcy is a legal process that allows you to seek relief from some or all of your financial obligations. There are several types of bankruptcy, depending on your situation. For example:

• Chapter 7: Known as liquidation bankruptcy. To qualify for Chapter 7, you must pass a means test. A means test compares your income level to the median income in your state. If your income is below the average, you may qualify for Chapter 7. In Chapter 7, you could walk away from your eligible debts entirely, but you might have to give up some of the things you own. If your income is too high, you will be directed to Chapter 13 bankruptcy instead.

• Chapter 13: Known as debt restructuring. If your income is above the median in your state and you have a regular source of income, Chapter 13 allows you to create a repayment plan to pay back debts over three to five years. You don’t have to give up your assets.

• Chapter 11: Also referred to as "reorganization." The primary goal of Chapter 11 is to allow (usually large) businesses to restructure their debts and create a plan to repay their creditors while remaining in business. Individuals are allowed to file Chapter 11, but usually opt for 7 or 13. 

How Bankruptcy Happens 

Due to life's uncertainties, bankruptcy can happen to anyone. Imagine a family consisting of a mother, father, and three children. For months, Dad hasn't been feeling well, and after many visits to doctors, his medical bills are piling up. He owns his own small business and Mom is a school teacher. They rarely have much extra left at the end of each month.

Nearly six months after he began feeling sick, Dad is diagnosed with an extremely rare form of cancer. Doctors offer some hope that he can survive the disease, but to know for sure, he'll need to undergo intensive, long-term treatment. While their health insurance covers some treatment, the family is saddled with medical debt. To make matters worse, Dad has a tough time with the treatments and can't work. 

With only Mom's income coming in, the family can’t keep up with their financial obligations, and have no way to pay the medical bills. Creditors are starting to call. Mom and Dad decide to explore bankruptcy. 

Common Issues That Could Contribute to Bankruptcy 

While as many as 66.5% of people who file for bankruptcy cite medical bills as the primary cause, it's not the only reason Americans turn to the bankruptcy courts for relief. While bankruptcy is often seen as a last resort, it’s a financial decision, nothing more, nothing less. Here are some of the other reasons people consider filing:

• Inability to pay bills

• Continuous calls from creditors

• Lawsuits from creditors

• Borrowing money to cover debt 

• Using money from retirement accounts to keep up with monthly payments

• Foreclosure or repossession threats

• Living paycheck to paycheck, with no extra funds for emergencies

• Unemployment or underemployment

• Divorce or marital separation

• High-interest debt, like credit cards

• Business failures

• Natural disasters

In other words, life happens, and there is no shame in looking for the way out that makes the most sense for you. 

Types of Bankruptcy

Since Chapter 11 is typically reserved for businesses, we'll focus here on the two types of bankruptcy for individuals.

Chapter 7

Chapter 7 bankruptcy can clear unsecured debts—like credit cards, medical debts, and personal loans—in months. Chapter 7 could involve giving up some of the things you own, although each state has its own rules regarding exemptions (the things you get to keep).

Assets considered nonexempt must be surrendered to the court, where a bankruptcy trustee sells them and distributes the money to your creditors. For example, if you own multiple cars or a nice boat, you may be required to surrender the boat and all but one of the vehicles. If there's money left over after using it to clear your debts, you get it back.

Once all accounts have been reviewed and money paid to creditors, the judge can discharge the bankruptcy, wiping out any unpaid balances. The process typically takes three to six months.

Chapter 13

With Chapter 13 bankruptcy, you get to keep your assets. However, their value will be factored into the monthly payment you have to make. You’ll commit to a monthly repayment plan. The amount you pay monthly is based on a bankruptcy trustee analyzing your finances and deciding how much you'll pay. 

Each year, you must submit tax returns and other paperwork to the trustee so they can adjust the payments if needed.

If you're considered low-income for the area where you live, your Chapter 13 bankruptcy plan will run for three years. If you're not low-income for your area, it will run for five years. After that time, any remaining balances on eligible debts are forgiven (discharged). 

It's important to note that a Chapter 13 repayment plan can be challenging to stick with because it typically means giving up all your disposable income for the three to five years you're on it. In fact, 58% to 61% of Chapter 13 cases end early, with no debt forgiveness. 

Why would someone commit to a repayment plan? Because bankruptcy protects you from legal action by creditors, at least temporarily. If your mortgage lender has started to foreclose on your home, a Chapter 13 bankruptcy could give you the opportunity to get caught up on payments so you don’t lose it.

If a Chapter 13 bankruptcy helps you get your home out of foreclosure or saves your business, it could be worth the sacrifice. 

Long-Term Impact of Bankruptcy 

According to FICO, a bankruptcy is always considered a very negative event in terms of your credit score. The impact it will have depends on your entire credit profile. Someone with a very high FICO Score can expect a considerable drop, while someone with negative items already on their credit report may see a more modest drop. 

In either case, you won't be able to take out a new mortgage for at least one year, although that's unlikely to matter much as you begin to recover from crushing debt. 

Interestingly, you can expect to be flooded with credit card offers shortly after filing for bankruptcy protection. Credit card companies know you can't file for bankruptcy again for several years. 

Here's how long bankruptcy remains on your credit report:

• Chapter 7: Up to 10 years

• Chapter 13: Up to seven years

• Chapter 11: Up to 10 years 

Alternatives to Bankruptcy 

• Debt consolidation: Combines multiple debts into a single loan with a lower interest rate, potentially simplifying your life and reducing monthly payments. This approach won’t save you money on what you already owe. 

• Debt management plan (DMP): You work with a credit counselor who negotiates with your creditors to pay off unsecured debts. They may request that your creditors lower your interest rates or waive fees or penalties. With this plan, you make a single monthly payment to the credit counseling agency, and it distributes that money to your creditors. Most DMPs last three to five years.

• Debt settlement: Involves you or someone working on your behalf negotiating directly with creditors to accept less than the total amount you owe and forgive the rest. 

• Other negotiation methods: Asking a creditor to modify your repayment plan or learning more about hardship programs or temporary payment arrangements offered by the creditor for those struggling financially. 

Determining whether bankruptcy is right for you is a big decision, but not one you must make alone. Talk to a variety of debt experts to explore your options, and find out the total cost of each one.