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This is Chapter 5 of 5 in our Ultimate Guide to Debt Relief series. Bankruptcy is a legal process and a formal acknowledgement that you cannot repay your debts. You may find it intimidating. However, bankruptcy is a good option to consider, helps protect your assets, and helps you quickly move on with your life once the process is complete. Because laws can be complex and intricate, this guide focuses on general information you should know about how bankruptcy works and the best way to approach it before deciding to file. What is bankruptcy? How does bankruptcy affect your credit? When is it a good idea to file for bankruptcy? What happens when you file for bankruptcy? How do you file for bankruptcy? What is bankruptcy? Bankruptcy is a legal process that allows you to hit reset on your finances if your debts are beyond what you can pay. A trustee or judge reviews all of your finances to determine whether or not to discharge the debts, which means that creditors can no longer collect. Creditors cannot take any action to collect once you’ve started the bankruptcy process without first seeking and getting permission from the judge. Bankruptcy does not discharge all of kinds of debt. Alimony and child support are not dischargable. In most cases, income taxes overdue less than three years and student loans are also not dischargable. Meeting with a bankruptcy lawyer to review your situation can help you understand which debts can be discharged and which ones can’t. You can file bankruptcy as an individual, maried couple, or business. There is even a process for filing bankruptcy if you have debts internationally. The two main kinds of bankruptcy for individuals are Chapter 7 and Chapter 13. Chapter 7 bankruptcy fully discharges eligible debt while protecting your assets. Chapter 7 bankruptcy typically protects all of your assets. Chapter 13 bankruptcy also helps protect your assets, but it doesn’t fully discharge your debt. Instead, Chapter 13 bankruptcy reorganizes your debt and creates a payment plan that lasts up to five years. “In Chapter 13, clients can reduce the amount owed on secured loans, reduce interest rates, reamortize loans, remove certain liens, extend the time to pay back taxes, reduce the amount owed on unsecured loans sometimes down to zero, and legally break leases,” says Dai Rosenblum, attorney and counselor of law. To get the best outcome, it’s wise to work with a lawyer with Chapter 13 expertise and experience. “You need a Chapter 13 specialist. If that lawyer does things correctly, you end up with a confirmable plan that the creditors are stuck with. There is no negotiating,” he adds. Depending on your situation, you may have to file a Chapter 13 bankruptcy. Otherwise, Chapter 7 is the ideal. “As a general rule, you prefer to do a Chapter 7. That eliminates all of your debt, and is completed, start to finish, in a few months. You do a reorganization plan because you need to, not because you want to,” says Rosenblum. While bankruptcy is an effective way to reset your finances and start over, it does have long-term effects on your credit. Back to List How does bankruptcy affect your credit? Bankruptcy stays on your credit report for seven to ten years, so it can make it difficult to qualify for low interest rates, new loans, and credit cards. But, it’s not all bad news. Bankruptcy can have a positive effect on your overall credit, too. “One surprising thing about bankruptcy is that it can improve your credit. All the debt that was formerly on your credit report is reduced to zero. Your credit ratio drastically improves, even though your credit score goes down. That shows a potential new lender that it will be easier to make future loan payments,” says Rosenblum. However, even though bankruptcy can lower your credit score and stays on your credit report for seven to ten years, bankruptcy can be a wise choice if you really need a reset on your finances. Back to List When is it a good idea to file for bankruptcy? If your debt has become overwhelming and impossible to pay, bankruptcy is worth considering because it can protect you from creditors. Consulting with a bankruptcy lawyer to learn more about how bankruptcy can help you understand it more and determine if it’s a good fit for you. “Without legal advice, many take assets that are completely exempt, such as 401(k)'s, and pay on debt that they don't have to. Most consumer bankruptcy lawyers offer a free first consultation, so there is no downside to gaining knowledge about how best to deal with debt. You shouldn't go to a credit negotiating company. They generally charge more than a lawyer does and reduce the amount of debt less than a bankruptcy does,” advises Rosenblum. Back to List What happens when you file for bankruptcy? Before you file for bankruptcy, you will be required to take a credit counseling course to help you determine if bankruptcy really is the best choice for you. Once you file for bankruptcy, you’ll have a meeting with your trustee. Your creditors can attend to ask for more information on your financial situation. Rosenblum offers more insight: “You attend a Creditors Meeting, which is conducted by a lawyer appointed as the court trustee. There is no judge and no courtroom. It is rare for creditors to be there. What rational business would pay to send someone to a meeting where they can't get anything out of it? You get a document called a 'Discharge Order' in the mail. With rare exceptions, that's the entire process,” he says. Once the judge determines which debts to discharge, you’ll no longer be legally required to pay those debts. Back to List How do you file for bankruptcy? While you can represent yourself when filing for bankruptcy, it’s a good idea to work with a lawyer. The judge and the court trustee must remain impartial and cannot help you if you represent yourself. A lawyer can help you avoid pitfalls and help you get a good outcome. Lawyers can be expensive. If you have a hard time stretching your budget to pay for one, you can find resources available to help or get free legal counsel. Depending on which kind of bankruptcy you’re filing, you may have the option to represent yourself. However, that may not result in the best outcome for you. “If you qualify for a Chapter 7, you can be your own lawyer, but there many traps for the unwary, and it is a bad idea. Even lawyers who are not bankruptcy specialists would probably not be able to get a confirmable Chapter 13 plan if they represent themselves. The list all of the things to look out for would be book length,” says Rosenblum. As you’re choosing an attorney, you’ll want to find one who specializes in bankruptcy law. “Bankruptcy law is complicated and unlike any other area of law. Lawyers should not dabble in bankruptcy,” says Rosenblum. Understanding what bankruptcy is and how it works will help you be more confident when seeking professional help with your debts and empower you to take control of your finances.
Your debt is overwhelming. You can no longer pay your bills and you are falling behind financially. Perhaps you receive weekly collection calls. You know there is no way for you to pay back your creditors, so you are seriously considering bankruptcy. However, before you start dialing an attorney, consider your other options, particularly debt settlement. What Is Bankruptcy? Bankruptcy is a legal procedure that reduces or eliminates debts. Eligible individuals receive court protection during the bankruptcy proceedings. Through the process, assets are either liquidated to pay off debts or the court creates a repayment plan to help the consumer pay off debts over time. There are two main types of consumer bankruptcy, Chapter 7 and 13. In 2016, approximately 62 percent of the 770,846 non-business bankruptcy filings were Chapter 7, making it the most popular type of filing. During Chapter 7 bankruptcy, your nonexempt assets are sold and used to pay creditors. After the process is complete, remaining qualified debts are discharged. Certain types of debt, such as tax and child support, are not applicable. On the other hand, during Chapter 13 bankruptcy the court works out a repayment plan, equal to the value of your nonexempt property. Once this is complete, remaining qualified debts are discharged. What Is Debt Settlement? Debt settlement is a very different process. A settlement company will analyze your debt and financial situation, often during a free consultation, and create a plan to help you get out of debt. Often, they will ask you to make monthly deposits into a designated savings account, rather than paying your creditors. The accumulating sum is used in the negotiation process. The debt settlement company negotiates with your creditors to settle your debt for a lower amount than you owe. Top 5 Things to Consider While deciding between bankruptcy and debt settlement, there are several important factors to consider. Both decisions have short-term negative consequences, but can be beneficial long term. Consider the following five things before you make your decision: Eligibility Credit Impact Resolution Time Cost Tax Consequences Eligibility The first critical factor is eligibility; not everyone qualifies for bankruptcy. Additionally, many debt settlement companies have minimum debt requirements. Before choosing your course of action, you need to determine if you qualify for either method. Bankruptcy: One important eligibility requirement for Chapter 7 bankruptcy is income. If your income is less than the median for your state and household size, you will likely qualify. In addition, your amount of disposable income is a large factor. If you have little income after taxes and necessary expenses, such as food, you may be eligible. Additionally, debt that exceeds half your income or would take over five years to pay off indicates that you are a good candidate for bankruptcy. Chapter 13 bankruptcy has different eligibility requirements. Your debt cannot exceed a certain amount, $394,725 for unsecured debts and $1,184,200 for secured debts. You also must have sufficient income to satisfy a repayment plan and be current on your federal income tax returns. Both types of bankruptcy have several additional strict requirements. If your debt was recently discharged in a prior bankruptcy case, dismissed from a case within the past 180 days, you have attempted to defraud your creditors, or you do not attend mandatory credit counseling, you will not qualify. Debt Settlement: Each debt settlement company establishes its own eligibility requirements. Most companies only work with unsecured debt. Additionally, few companies operate in all 50 states. You need to verify which companies service your state. Finally, most debt settlement companies have a minimum debt requirement. Many companies require $7,500 to $10,000 in debt. However there are some companies that require as little as $5,000. If you have less than $5,000, you should look seriously at other debt relief options, such as debt management plans or consolidation. Credit Impact Both bankruptcy and debt settlement will negatively impact your credit score and report. The severity and the length of the impact needs to be seriously considered. Your credit score affects your ability to apply for loans and may dissuade landlords from renting to you. It significantly impacts your interest rates on loans, credit cards, and mortgages. Moreover, if you apply for a job with security clearance or in a financial industry, your credit score may be an influential hiring factor. After either method, you may consider using a credit repair company to help monitor and improve your credit. Bankruptcy: Bankruptcy will greatly impact both your credit score and report. Your score could decrease by 160 to 220 points. Chapter 7 bankruptcy stays on your report for 10 years; however, your discharged debts are removed after seven years. On the other hand, Chapter 13 bankruptcy stays on your report for seven years. You pay off many of your debts over a three to five year period; these may remain on your report for longer than seven years. Debt Settlement: If your debts are settled for less than the full amount, your credit report may read "Settled" rather than "Paid in full". Additionally, part of the settlement process involves making payments to a designated savings account, rather than paying your creditors. These missed payments will decrease your score. If you are already late on your payments, the impact will be less severe; however, if you have a high score, the drop will be more dramatic. In either case, debt settlement is still less damaging to your credit than bankruptcy. Resolution Time Debt resolution is rarely a quick process. Compare the length of each option before making your final decision. Think about your future financials goals and how quickly you need your debt resolved. Bankruptcy: Bankruptcy can take a few months or years. Chapter 7 bankruptcy is the shortest option. It typically takes four to six months. In contrast, Chapter 13 bankruptcy takes between three and five years. Over these years, you make regular payments as outlined in your court-approved repayment plan. Debt Settlement: The settlement process varies greatly based on individual circumstances. Many companies, such as Accredited Debt Relief, aim to have their clients debt free in two to four years. However, speaking to a company about your specific situation will give you a more precise time estimate. Cost If you are considering these two options, then you are struggling with notable financial hardships. You want to choose the option that makes the most financial sense. Take time to calculate the cost and see which option is best for you. Bankruptcy: There are several costs associated with bankruptcy. Chapter 7 costs $335 in filing fees, and Chapter 13 costs $310. In addition, many people hire bankruptcy attorneys, with an average fee of $1,250. You do have the option to file without representation, called pro se. However, a study of 2014 Central District of California bankruptcy courts found that only 48.2 percent of pro se cases resulted in a bankruptcy discharge (released liability from debts) compared to 82.1 percent of attorney represented cases. Though legal representation offers a higher success rate, it dramatically increases costs. Finally, one of the conditions of bankruptcy is credit counseling. Depending on your income, this could range from $0 to $50. Debt Settlement: Companies typically charge a percent of your enrolled debt, though a few companies base fees on saved debt. Pacific Debt Inc. charges between 15 and 25 percent of total enrolled debt for their services, a typical fee for the industry. The range varies based on state and amount of debt. Be wary of companies that charge upfront fees. Tax Consequences Debt relief has surprising tax repercussions. Familiarize yourself with these consequences. You do not want to pay off your debt only to receive a hefty tax bill at the end of the year. Bankruptcy: Canceled debt, in both Chapter 7 and 13 bankruptcies is not included in your income. Unlike other forms of forgiven debt, this is not taxable. To report this exclusion, you will need to fill out line 1a on Form 982. Debt Settlement: When your debt is canceled, your creditor will report it to the IRS through Form 1099-C. The IRS views this forgiven debt as taxable income. Unless you can prove insolvency (your debts exceed your assets), you will be required to pay taxes on the forgiven amount. The Final Choice As you decide your course of action, be sure to consider the aforementioned factors. You first need to establish if you qualify for bankruptcy or debt settlement. Your credit score will be impacted less drastically with debt settlement. Also consider the time and cost. Chapter 13 and debt settlement will most likely take a few years, while Chapter 7 only lasts a few months. During Chapter 7, your assets will be liquidated. If you are interested in retaining your possessions, debt settlement or Chapter 13 may be better options. Finally, remember that debt settlement is often taxable; include this in your cost estimate as you weigh your options. If you decide to file for bankruptcy, be sure to find a reputable attorney. They can give you specific legal advice for your unique situation. If you decide to resolve your debts with a settlement company, compare top-rated companies. You can read reviews from real customers and compare companies at BestCompany.com.