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What is bankruptcy and how do I avoid it?

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If your debts have become unmanageable and you feel there is no other way out, you may be wondering if bankruptcy is your next logical step. While it’s true that nobody wants to leave their financial fate in the hands of the courts, there are times when bankruptcy may be the only solution.

What is bankruptcy?

Bankruptcy is a formal legal process that can help absolve consumers of some of their debts or reorganize their debts so they can reasonably be paid off. Different types of bankruptcy can lead to different outcomes, and the unique types of bankruptcy are also geared toward different types of consumers.

Most consumers who file for bankruptcy do so with the aid of a bankruptcy attorney. Either way, bankruptcy begins when a debtor files a petition for bankruptcy with a bankruptcy court. Individuals can file for bankruptcy on their own, and couples can file together. Businesses can file for bankruptcy using their own separate processes.

What are the types of bankruptcy?

There are two main types of bankruptcies for consumers to consider, each of which can make sense depending on a consumer’s financial situation.

Chapter 7 bankruptcy

With Chapter 7 bankruptcy, property is sold and the proceeds are used to pay off debts. This type of bankruptcy is usually pursued by consumers who do not earn enough money to repay the debts they have.

Chapter 13 bankruptcy

With a Chapter 13 bankruptcy, some unsecured debts may be forgiven. However, remaining debts are reorganized and set up to be repaid over a specific length of time (usually three to five years). This type of bankruptcy is often utilized by consumers who earn enough to repay their debts but need assistance and a fresh start.

How bankruptcy works

How your bankruptcy will play out depends on the type of bankruptcy you file. With Chapter 7 bankruptcy, for example, a trustee is typically appointed to take over your property and assess it for resale. Property of value you own can and will be sold in order to raise money for your creditors. With that being said, you may be able to keep important personal items and potentially even real estate since the rules regarding your Chapter 7 bankruptcy vary depending on where you live.

By contrast, you usually keep your property when you file for Chapter 13 bankruptcy. However, you need to earn a regular income and agree to repay most of your debts on a repayment plan approved by the courts. A trustee will work with you to collect payments, which they’ll use to repay your creditors according to the plan.

While bankruptcy can be a relief for consumers who are able to discharge some of their debts, not all debts can be discharged. Most tax debts cannot be discharged in bankruptcy. You also typically cannot discharge child support payments, alimony, most types of student loans, court fines, criminal restitution and amounts owed due to personal injury caused by driving under the influence.

Why someone would file for bankruptcy

Filing for bankruptcy is usually seen as a last resort, mostly due to the lasting impact filing can have on your finances. A recent bankruptcy can easily cause your credit score to plummet, which will likely make it difficult to purchase a home, buy a car or qualify for other types of loans. Filing for bankruptcy can also cause your insurance rates to go up.

However, consumers who file for bankruptcy usually do so because they are unable to navigate their way out of a financial crisis on their own. While bankruptcy is a permanent and drastic move that has many downsides, the process is intended to get people on a sustainable path toward better finances. Because debts can be entirely discharged throughout the process, filing for bankruptcy can be seen as a godsend for those who are truly struggling and have few other options, if any, to consider.

How do I know if I should file for bankruptcy?

If you are overwhelmed by your financial situation and things only seem to get worse with each passing month, you may want to consider bankruptcy as a way out. There are plenty of situations where it makes sense to file for bankruptcy despite the consequences.

Here are some reasons to consider filing:

  • You have so much debt that it would be impossible to pay it off during your lifetime.
  • You’ve experienced an extreme loss in income that makes it impossible to repay debts without any help.
  • You have been sued for an extraordinary amount of money you cannot repay.
  • Your financial situation is grim, and you need a fresh start.
  • Collections agencies and creditors are calling you around the clock and you need third-party help.

Does bankruptcy affect my credit?

Having a bankruptcy on your credit report will have a negative impact on your credit. A bankruptcy will make it harder to get loans or credit in the future, and your rates will be higher. How long a bankruptcy stays on your credit report depends on the type of bankruptcy you file.

Chapter 7 bankruptcy can stay on your credit reports for 10 years, while Chapter 13 bankruptcy only stays on your reports for seven years. However, the impact on your credit score will lessen over time. For example, a bankruptcy filed last year will have a greater impact than a bankruptcy filed five years ago.

Bankruptcy during COVID

The COVID-19 Bankruptcy Relief Extension Act of 2021 was signed by President Biden on March 27, 2021. That extended most of the provisions of the COVID-19 Bankruptcy Relief Act into March 2022.

A few of the important bankruptcy-related provisions are that COVID-related stimulus checks are not considered income for purposes of bankruptcy. Also, people going through the Chapter 13 bankruptcy process now can change their repayment plans if they’re experiencing financial hardship because of COVID-19.

Tips to avoid filing bankruptcy

Bankruptcy is intended as a last resort for people who have debts they cannot pay off through other means. That is one reason the credit penalty is so severe — if you can avoid bankruptcy, it is usually in your best interest to do so. Here are a few tips to avoid filing bankruptcy.

The first tip is to try and cut your expenses as much as possible. If you aren’t able to balance your budget so that your income is more than your expenses, you may find that bankruptcy does not give you the clean start you’re looking for. You can also try to negotiate with your creditors to see if they will accept an alternative payment plan.

Depending on the types and amounts of your debts, you might also consider debt consolidation. You might be able to consolidate your debts by applying for a personal loan and using the proceeds to pay off your other debts. You can also work with a company that specializes in debt consolidation. If you work with a company, find one that has positive reviews and does not charge an excessive amount of fees.

Next steps

If you aren’t sure which move you should make next, you may want to spend some time comparing all your options. Learn about the types of bankruptcy, what it takes to file and consider all the bankruptcy alternatives you could pursue instead, along with their pros and cons.

A credit counselor can also help you determine how bad your financial situation is and if you could potentially reorganize your finances yourself. At the very least, a highly qualified credit counselor could help you get another perspective on your situation and determine whether bankruptcy is right for you. Many bankruptcy attorneys offer a free consultation to help you figure out your next best steps.

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Written by
Holly D. Johnson
Author, Award-Winning Writer
Holly Johnson writes expert content on personal finance, credit cards, loyalty and insurance topics. In addition to writing for Bankrate and, Johnson does ongoing work for clients that include CNN, Forbes Advisor, LendingTree, Time Magazine and more.
Edited by
Loans Editor, Former Insurance Editor