Consumers with little hope of paying off debt are turning to bankruptcy as a solution.
Thirty percent more Americans filed for bankruptcy in the year through June compared with the previous 12 months. Filing for bankruptcy can hurt financially, but for some, it offers a much-needed path out of financial disaster. Before you decide whether to file for bankruptcy, here are a few points to consider.
A Little History
In 2005, Congress passed laws making it more difficult for consumers to file for bankruptcy under Chapter 7, which allows consumers to erase most of their debts. Prior to that, a judge decided Chapter 7 eligibility on a case-by-case basis. Ineligible consumers had to settle for a Chapter 13 bankruptcy, in which they are required to pay back a portion of their debts based on a payment plan.
The new laws introduced a standardized "means test" based on the median income of your state of residency. If your income is below the median income, you are eligible for Chapter 7. If your income is above the median, your eligibility depends on a complex calculation of disposable income. (Use this online calculator to get an idea of your eligibility.)
But while the new laws make the process of filing for bankruptcy more complicated and costly, they don't really change who qualifies, according to Henry Sommer, president of the National Association of Consumer Bankruptcy Attorneys, or NACBA. "Almost everybody who was eligible before 2005 is still eligible now," says Sommer. "The new laws really only affected 0.5% of the cases, but many people don't realize that."
Bankruptcy should remain a solution of last resort. Many consumers find themselves in dire straits because of budget- and credit-management problems. Bankruptcy may provide a fresh start, but without a change in borrowing and spending habits, you risk finding yourself back in the same situation facing the same problems.
Twice as many Americans filed for Chapter 7 bankruptcy as for Chapter 13 during the 12 months through June. Chapter 7 bankruptcy is popular because it wipes out consumer debt, with the exception of some types such as mortgages, alimony payments and certain taxes. During the process of Chapter 7 bankruptcy, all non-exempt property is sold and the proceeds go toward paying creditors. (What property is exempt in bankruptcy proceedings varies from state to state, but often includes some furniture and personal items.) The remaining balances of the forgivable debts are wiped clean and the consumer has a chance to start over.
Chapter 13 bankruptcy is also called reorganization bankruptcy since debts are organized into a three- to five-year payment plan arranged through bankruptcy courts. The payment plan provides greater flexibility for catch-up payments on a mortgage or car loan, and doesn't involve selling property to pay creditors. Nevertheless, the courts can require some selling of property unless you can prove you can afford the payment plan.
The Effect on Credit
A bankruptcy won't automatically have the devastating effect on your credit that many consumers fear. While a bankruptcy will remain on your report longer than other entries such as credit cards or car loans -- 10 years compared with the standard seven -- most consumers can still borrow money, just not at preferred rates. (NACBA's Sommer does mention, however, that stricter lending requirements caused by the ongoing credit crisis may put even less-preferred rates out of reach of consumers with bankruptcies on their credit histories.) And a credit score already battered by late payments and defaults in the lead-up to bankruptcy won't necessarily drop lower after bankruptcy.
Find a Bankruptcy Lawyer
Consider hiring a bankruptcy lawyer even before you think it's time to file. A good attorney will start by discussing your options, including those that don't involve filing for bankruptcy, and their potential outcomes. And if bankruptcy is your only choice, your attorney will file the relevant paperwork and help you pull together the required documentation. To find a bankruptcy attorney, ask for references from a lawyer you already know or check the NACBA Web site for a list of its members. Most attorneys offer a free preliminary consultation, after which fees can range from $1,500 to $2,500 for Chapter 7 and $2,000 to $4,000 for Chapter 13.