Going for broke: Now may be
the best time to file for bankruptcy
By Holden Lewis • Bankrate.com

"Neither a borrower nor a lender be," huffed the blowhard Polonius to his son in Hamlet.

If you haven't paid attention to Polonius -- and face it, who does? -- and you can't repay your debts, here's a piece of advice worthy of the Bard: Get thee to a bankruptcy attorney.

Bankruptcy reform is winding its way through Congress, and in some cases it makes more sense to file under the current regulations. So if you must file and you have the luxury of choosing the timing, you might want to do it sooner rather than later.

Types of bankruptcy
Consumers generally choose between two types of bankruptcy: Chapter 7 and Chapter 13. There are other chapters, such as 11 and 12, which usually are invoked by businesses and family farmers, respectively.

Chapter 7 gives the debtor a quick "fresh start" by forgiving unsecured debt, which is debt not backed by collateral. Most credit card charges and signature loans are unsecured debt, so a Chapter 7 filer doesn't have to repay them.

Home mortgages and car loans are secured debts because they are backed by collateral. Bankrupt debtors continue making mortgage and car loan payments if they can.

Chapter 13 bankruptcy gives the debtor breathing room to pay all or part of unsecured debts. The bankruptcy court eyes the debtor's income, living expenses, secured debts and ability to pay unsecured debts, then sets up a three- to five-year repayment plan. The debtor sends a monthly check to a trustee, who pays creditors according to complex formulas. The creditors might get all the money owed them or a portion of it.

Getting Congress to listen
The number of personal bankruptcy filings has risen steadily in recent years, although filings dipped in the first quarter of 1999. Still, even as they fill millions of mailboxes with credit card solicitations, lenders complain that consumers all too often charge more than they can repay. The American Financial Services Association says irresponsible borrowers file too many "bankruptcies of convenience," a term it designed to capture the attention of Congress.

And the credit industry's friends and countrymen on Capitol Hill have lent their ears. Legislation introduced in both the House and Senate would reform bankruptcy laws by:

• Establishing means-testing
• Imposing counseling and education on debtors
• Removing vehicles, expensive houses and some household goods from bankruptcy protection

Who might want to visit a bankruptcy attorney soon instead of after the bankruptcy law is reformed?

As a hypothetical example, let's say you are single, living alone and work in sales. You earn $30,000 a year plus commissions. You have a year of $400-a-month payments remaining on your 3-year-old car. Your mortgage payment, which includes principal, interest, property taxes and insurance, is $1,500 a month. Recently you bought $6,000 worth of furniture on a credit card; you have been paying for a lot of stuff with plastic and your total credit card payments are $750 a month.

Unfortunately, things aren't going well at work. Your sales are down and you're not collecting the commissions you had budgeted for. In fact, you had expected to earn $60,000 this year with commissions, but now you're on track to earn $42,000.

That $1,500-a-month mortgage payment was a stretch at $60,000 a year. At $42,000? Forget it. You can feel yourself spiraling down into a chasm of debt. You redouble your efforts at work.

While you're doing that, you probably should have a chat with a bankruptcy attorney. If you file for bankruptcy after reform is enacted, it is possible that you would have to repay some debts that you wouldn't have had to pay before. If you wait, the furniture dealer might even threaten to repossess that ottoman and easy chair. And if you wait, you might be forced to go to a credit counselor and attend financial planning classes, even if you don't think you need those services and you would rather spend that time earning the commissions you so desperately need.

Difference of opinion
Depending on whether they identify with lenders or debtors, experts disagree about which reforms are needed or whether bankruptcy reform is a good idea in the first place. The arguments are mostly over means-testing and the way "reasonable expenses" are computed.

"The whole purpose of the bill is to discourage anyone from filing for bankruptcy," says Henry Sommer, a consumer bankruptcy attorney in Philadelphia. "The purpose is to make bankruptcy expensive and ineffective and untenable and unfeasible in many cases."

If that is meant as criticism, the credit industry is unruffled. Lenders make it no secret that they want to make bankruptcy less convenient, especially for yuppies who play the system with the finesse of a late-for-work soccer mom sipping a latte in a speeding minivan.

"The stigma of bankruptcy has diminished so much that people with substantial income have come to see it as a financial planning tool in some instances," says Jeffrey Tassey, senior vice president of the American Financial Services Association. "The costs of these bankruptcies of convenience are passed on to the rest of us in the form of higher interest rates and higher prices for goods and services."

One in 68 families nationwide filed for bankruptcy last year, and the credit industry claims that those bankruptcies cost each household $400 in higher interest rates and fees. Consumer advocates dispute that figure, pointing out that people with credit problems pay the higher interest rates and fees.

Chapters and convenience
Tassey says that about 10 percent to 20 percent of Chapter 7 filings are bankruptcies of convenience, where the filers have the capacity to repay at least some of their debt and there is evidence that the filing was planned.

"There's not a lot of bankruptcies there, but there's a lot of money there, and that's why we see the need for a needs-based approach," Tassey says.

As you might expect, advocates for lenders and borrowers disagree over whether there really is a lot of money there. An Ernst & Young study paid for by Visa and MasterCard says 10 percent of Chapter 7 filers would have had to file under Chapter 13 if means-testing had been required in 1997. The study said those filers would have paid $3 billion more than they would have paid otherwise.

On the other hand, an independent study by Creighton University School of Law professors Marianne Culhane and Michaela White found that means-testing would force about 3 percent of Chapter 7 filers to instead file for Chapter 13 protection. The professors maintain that lenders would get back less than $1 billion a year under bankruptcy reform.

"(T)he vast majority of Chapter 7 debtors belong in that chapter," Culhane and White concluded in the report. The research was paid for by the American Bankruptcy Institute, a nonpartisan organization dedicated to research and education on matters related to insolvency.

The price of reform
The Congressional Budget Office has weighed in with an estimate that it would cost the federal government $333 million over five years to implement the changes called for in the House version of bankruptcy reform. Most of the money would pay for administering means tests, providing education and data collection, and paying additional judges' salaries.

The House version of bankruptcy reform, which was introduced by Rep. George Gekas, R-Pa., was passed in May and came down on the side of creditors. The Senate is expected to debate a similar bill at the end of June. A spokesman in the office of Sen. Charles Grassley, R-Iowa, who introduced the bill, has said it is on a fast track. It has bipartisan support: one of the first co-sponsors was Sen. Joseph Biden, a Delaware Democrat.

Now two senators are threatening to add abortion-related amendments that could endanger the bill's chance of being passed. Sen. Charles Schumer, D-N.Y., wants to require bankrupt people who violated laws protecting abortion clinics to pay their fines. Sen. Bob Smith, R-N.H., wants to prohibit bankrupt doctors from writing off penalties they owe from abortion-related medical malpractice claims. A frustrated Biden says abortion-related amendments are a good way "to make sure nothing happens" with legislation.

Much debate has centered on means-testing, in which the finances of people filing for Chapter 7 bankruptcy are scrutinized to make sure they really need to get a fresh start. Means-testing is designed to weed out filers who can afford to pay some of their debts under Chapter 13 of the bankruptcy code.

"This would change the central feature of bankruptcy law, which is that you can go into Chapter 7 if you wish to, regardless of your ability to pay," bankruptcy attorney George Wallace says.

Critics say that means-testing is subject to manipulation. For example, say Culhane and White, someone could get a car loan or other kind of secured debt to get that all-important push over the edge into Chapter 7. Or a debtor could give generously to charities, reducing disposable income enough to be eligible for Chapter 7.

While critics of means-testing maintain that it gives savvy debtors enough room to escape Chapter 13, Wallace says it is a net designed to catch the big fish while letting the small fry swim through. He cites the example of a suburban Washington family that spent $300 a month on cellular phones and $600 a month on entertainment, yet filed for bankruptcy. There is room in such a budget to cut spending and pay debts, he says.

The definition of reasonable
Another area of debate has to do with defining reasonable living expenses. The proposed legislation uses Internal Revenue Service standards that are used in tax payment plans.

The problem is that there is confusion and disagreement over what the standards mean. For example, the IRS lumps housing and utility expenses together, but bankruptcy courts prefer to separate them because it matters whether someone is paying a mortgage -- which is a secured debt -- or renting.

Likewise, experts disagree over how to interpret transportation expenses. Some debtors are making payments on relatively new cars, and others own old cars outright, so they are not making payments. What kind of transportation expenses should be allowed for someone who has a paid-off car that will have to be replaced within a few years? The answer to that remains unclear.

Even critics of the proposed reform agree that some bankruptcy changes are needed.

"The system might need reform, but not these reforms," says Gary Klein, an attorney with the National Consumer Law Center in Boston and an opponent of bankruptcy reform. "I would like to see some crackdown on high-income debtors who move to Texas or Florida to take advantage of high homestead standards."

Indeed, the House version of bankruptcy reform tackles the issue of debtors who own expensive houses. In some cases, a house worth more than $250,000 would not be protected.

Sins of credit card firms
And Klein says he would like to see that balanced with limits on abusive credit card lending. Overextended debtors are pursued now because they are charged higher interest rates and fees. When credit card holders miss payments, they pay penalties and the interest rate usually rises -- so lenders make money off that type of customer.

"I think the credit card industry is scapegoating the bankruptcy industry for losses that are their bad loan losses," Klein says. "They're lending money to people who can't afford to pay."

Although the thrust of the proposed legislation is to give more power to creditors, observers don't foresee a rush to bankruptcy courts if a reform bill is passed. For most people, bankruptcy is an animal that pounces on the unwary rather than big game that is deliberately stalked.

Sommers notes, "Most people who file for bankruptcy, six months before, they didn't think they would."

-- Posted: June 18, 1999