While individuals should make every effort to get out of debt using strategies like budgeting and consolidation, sometimes this is simply not possible. The end-of-the-line option is bankruptcy, which is a legal declaration of the inability to pay off debt.
People should not take bankruptcy lightly. While the process can help give individuals financial breathing room, there are also serious consequences that make it best used as a last resort.
At the same time, bankruptcy can prevent car repossession or home foreclosure and even stop wage garnishment or the other legal actions that creditors can take against debtors. Individuals need to carefully consider benefits, consequences, and other options before making a decision.
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Declaring bankruptcy has consequences.
Bankruptcy discharges all or most of an individual’s debts. As a result, it causes a serious hit to one’s credit. In fact, the issue will stay on one’s credit report for 7 to 10 years depending on the type of bankruptcy granted.
This may not sound like a major problem at first. However, having a bankruptcy on your record can prevent you from opening any new lines of credit, making it difficult to make larger purchases. Additionally, low credit scores can affect people’s ability to secure a lease or mortgage – or even a job.
Individuals who are considering bankruptcy may already have negative information, such as delinquent accounts, on their credit report. This makes the credit implications seem like they’re not so bad. At the same time, the effects of a bankruptcy last much longer than these other issues. Experts typically recommend bankruptcy only for those who have considerable debt – in excess of $15,000. Otherwise, negotiating new terms with debtors could be the better approach.
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Bankruptcy has limitations.
The other issue to consider is that people may still have debt even after they have declared bankruptcy. Not all debts and obligations can be discharged, so that slate may not be wiped completely clean.
For example, alimony and child support are typically not discharged. Debts incurred immediately prior to filing are not always discharged. Additionally, most student loans will stay with the debtor, although they can be forgiven in certain jurisdictions under certain circumstances. Other debts that typically cannot be discharged include tax debts and debts incurred as a result of personal injury related to driving while intoxicated.
Furthermore, bankruptcy does not protect cosigners. The purpose of a cosigner is to guarantee a loan should the debtor default. For that reason, cosigners will need to pay all or part of the remaining debt.
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There is a specific process for filing for bankruptcy.
Before individuals file for bankruptcy, they must typically go through credit counseling with an approved provider. The list of approved providers can be found online through the United States Courts website. Only a handful of counselors are approved, but they may provide online or telephone sessions so that the inconvenience is minimized.
Once the necessary counseling is completed, individuals can secure a bankruptcy attorney to guide them through the process. While legal representation is not strictly required, it makes the process much easier. Free legal service is available for people who do not have the money to hire an attorney. The American Bar Association has more information about free legal counsel.
Bankruptcy must be filed in a federal court and the process typically demands several hundred dollars in fees. The exact process for declaring bankruptcy depends on the type of bankruptcy pursued.
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There are different types of bankruptcy.
Several different types of bankruptcy exist, but the most common for individuals or couples are Chapter 7 and Chapter 13. About 70 percent of noncommercial bankruptcy cases are filed under Chapter 7, which is meant to completely discharge debts and relieve debtors of any repayment responsibility.
Under this arrangement, certain assets may be sold through a trustee appointed by the court. The proceeds of sales cover administrative fees. Any leftover proceeds are distributed among creditors. Filers can keep certain assets, but the exact exemptions vary from state to state.
In each case, filers can choose to follow state or federal law depending on which best suits their situation. Federal law allows people to keep job-related tools, household items, and up to $16,500 in home equity and $2,575 in car equity. These amounts are doubled for married couples. Under Chapter 7, individuals also keep their pension, welfare, unemployment, Social Security, and veteran benefits.
The other common option is Chapter 13 bankruptcy, which requires the repayment of some debts. In return, people get to keep their property. People who earn too much to be eligible for Chapter 7 bankruptcy may choose to file under Chapter 13.
This option only works if total debt does not exceed a fixed amount, although this amount is periodically reviewed and changed. The Chapter 13 repayment plans lasts for three to five years, after which time all remaining debts are forgiven. If the plan is not completed successfully, debtors can then file for Chapter 7 bankruptcy.
Individuals may also file under Chapter 11, although this is typically used to reorganize businesses. Debtors with assets and/or debt in the United States and other countries will need to file under Chapter 15. Chapter 12 is intended for family farmers and fishermen.