When should I file for bankruptcy?

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Bankruptcy exists in America for many good reasons. But the decision to file for bankruptcy when faced with overwhelming debt is one that most, including myself, consider—again with good reasons—the last resort option. Let’s look at bankruptcy a little closer this week.

Types of bankruptcy

First, a basic primer: there are two types or “chapters” of bankruptcies that apply to individuals—chapters 7 and 13. In a chapter 7 bankruptcy filing, almost all debt is erased while a chapter 13 filing reorganizes your debt so that you can repay some portion. Chapter 7 bankruptcies require a means test to determine that you really do not have the funds (or means) to repay your debt. A means test is not technically required in a chapter 13 filing (more on that below).

It is important to understand that even in a chapter 7, all debt is not discharged. Taxes, student loans, secured debt, child support or alimony are at the top of the list of debts that usually cannot be erased through bankruptcy.

When and how to file, and what to expect

Although it is technically not a requirement, making the decision to file for any type of bankruptcy is likely to be a sounder one with the assistance of a qualified bankruptcy attorney. This is a major life decision, after all, that is going to have an effect on your life for years to come.

Yes, it will likely cost you money to hire an attorney (although your local legal aid society may be able to help you here). The oft-quoted phrase from good old Honest Abe sums it up nicely: “He who represents himself has a fool for a client.”

That said, you will have to go through a means test to determine for which chapter you will qualify. Although I said earlier that a chapter 13 does not require a means test, you are required to prove your income in order to determine the amount of debt you will be required to repay.

Filing a chapter 13 means you are going to turn over the management of your accounts to the court and they will determine how much you will pay your creditors over the term of the bankruptcy. You will be effectively put on a very strict budget by the court, which will determine how much of your disposable income you can afford to use to pay your debt and how much of your income you will get to live on for the next several years.

As for how long it takes, a chapter 7 bankruptcy is usually completed or discharged in four to six months. A chapter 13 takes between three and five years to complete.

How does bankruptcy affect your credit?

A chapter 7 remains on your credit report for 10 years; a chapter 13 stays there for seven years. You should also know that you can’t file a second chapter 7 for eight years and it takes two years after discharge to file again for a chapter 13. So, with only one shot in your cannon, I caution you to be very sure a bankruptcy will solve your problems before you light the fuse.

Both chapters will bring your score down significantly in the beginning, but if you use this as a “fresh start” you should do so by committing to paying your new bills on time, every time and watching the use of any credit you may still have access to. If you start out with a credit score of 700 or higher, point losses of up to 200 are not uncommon with a bankruptcy. If your score is 680 or less, you are probably looking at a loss of 130 to 150 points.

However, the effect of a bankruptcy often goes beyond these devastating hits to your credit report and score. Having a bankruptcy on your file can be a red flag to potential landlords and employers and could even impact your insurance rates. This is to say nothing of the emotional toll it may cause. That’s why you need to be really sure this is the right thing to do—it may be, but just be sure.

Bankruptcy alternatives

Tighten your budget

To help you be sure, I suggest that you take a hard look at what you owe and your current income. A bare-bones budget is called for to see if you can come up with the funds to get yourself out of the hole that you have dug for yourself. This means limiting your spending on nonessentials—think premium cable channels and dining out, for starters.

Selling some items may be a good way to come up with extra funds, or using online services to offer items for sale. Target any extra money you make for your debt. You might consider a second or part-time job to supplement your income and again use it for your debt. You can also look into a debt consolidation loan to see if lowered interest rates and longer payback times will help.

Ask your creditors for relief

Reach out to your creditors and see if you can come up with better terms or settle for less than you owe. Don’t be afraid to tell them you are considering bankruptcy. If you end up filing, they will find out anyway and if there is any way to avoid doing so it will be better for both of you.

Contact a credit counselor

If all of these ideas seem overwhelming (and I don’t blame you if they do), there is help available. Contact a credit counselor. You’ll have to do that anyway if you decide to file for bankruptcy, but my suggestion is to make the contact before you decide about filing for bankruptcy.

Your credit counselor will go over all of your options (including bankruptcy) and help you come up with the best plan for you. You can find a qualified nonprofit agency that offers bankruptcy counseling through the National Foundation for Credit Counseling.

If overwhelming unsecured debt is what has brought you to this point, a debt management plan might be the answer. Similar to a chapter 13, this is a systematic approach to paying off unsecured debt in three to five years. The big differences are less damage to your credit, you get to live on a budget you choose and you will have ongoing support from a certified professional if you need to change payments, ask your creditors for more help or can’t make a payment due to changed circumstances.

While your score may suffer somewhat if you go this route (because your credit cards will be closed), if you are at the point of considering bankruptcy anyway I suspect your score has already suffered a lot. And because of the fixed timely payments required to stay on the plan, your score will bounce back sooner than you may expect. Certainly sooner than having a bankruptcy on your credit file, with all of its attendant problems.

Good luck!

Have a credit question for Steve? Drop him a line at the Ask Bankrate Experts page.