Walking away from debt vs. filing bankruptcy

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Walking away from your debt, also known as defaulting, could seem like your best option if you’re struggling to keep up with bills. However, walking away from debt won’t solve all of your problems; the lender can still try to sue you for the remaining amount or sell the loan to a collection agency. If you’d like to wipe the slate clean, bankruptcy could be a viable alternative.

What is the difference between default and bankruptcy?

Defaulting on a loan means that you’ve violated the promissory or cardholder agreement with the lender to make payments on time. Each lender has its own requirements on how many missed payments you can have before it considers you in default. In some cases, that may be as little as one missed payment or as many as nine missed payments.

Filing for bankruptcy is a legal process that involves listing out your debts and assets and finding a way to resolve those debts. A judge will decide if any of your debts can be discharged and if your assets will be used to pay off the outstanding balance. The judge will also decide which assets you’re allowed to keep and which can be taken from you.

Default and bankruptcy usually go hand in hand. Many borrowers default on their loans and then subsequently file for bankruptcy.

What happens when I default on my loan?

When you default on a loan, the debt will often be sold to a collection agency, which will then try to collect on the amount owed. The lender can also try to sue you in court to garnish your wages or even try to put a lien on your house to collect some of the profits when you sell the home.

The type of action that is taken against you largely depends on whether your debt is secured or unsecured. Secured debt uses your asset as collateral, which can be repossessed if you default. For instance, if you default on an auto loan, the lender will often try to repossess the vehicle.

Unsecured debt, like credit card debt, has no collateral; in these cases, it’s harder for a collection agency to recoup the debt, but the agency may still take you to court and attempt to place a lien on your home or garnish your wages.

A default will also result in a huge drop in your credit score, ultimately staying on your credit report for seven years. Having a default could make it very difficult to qualify for another loan or credit card.

What happens when I file bankruptcy?

Filing for bankruptcy after you’ve defaulted can protect your assets from being seized by the lender or creditor.

In a Chapter 7 bankruptcy, the court will decide which of your assets to sell in order to repay your creditors. Any remaining debt will be discharged, except for student loans, child support, taxes and alimony. This type of bankruptcy will stay on your credit report for 10 years.

If you file for Chapter 13, you may be able to keep more of your assets while discharging some of your debts. The debt that is not discharged will be put on a three- to five-year repayment plan. This will stay on your credit report for seven years.

Your credit score will likely go down significantly if you file for bankruptcy — by at least 130 points, but sometimes by as much as 200 points or more. If you work in an industry where employers check your credit as part of the hiring process, it may be more difficult to get a new job or be promoted after a bankruptcy.

Jay Fleischman of Money Wise Law says that if you have credit cards, they will almost always be closed as soon as you file for bankruptcy. Getting another loan or credit card will also be very difficult in the early stages after bankruptcy. But as time goes on, the bankruptcy will affect your score less and less — if you’re responsible with your credit.

If you’re considering bankruptcy, it’s a good idea to talk to a bankruptcy lawyer. They can advise you on the best options for your situation, which kind of bankruptcy is best for you and how to protect your assets, like your home or future earnings. Fleischman says that he often talks to people who have wiped out their nest egg trying to repay their debt before filing for bankruptcy, not realizing that bankruptcy courts rarely touch your retirement accounts.

Should I file for bankruptcy or default on my loan?

Defaulting on a loan and filing for bankruptcy are not opposite choices. In fact, Fleischman recommends defaulting on a loan before filing for bankruptcy. If you haven’t defaulted, it might indicate that you haven’t given yourself enough time to allow your financial situation to improve.

If you do default, then filing for bankruptcy can protect your assets from being seized by creditors. It can also protect you from having future wages or an inheritance garnished. “Bankruptcy is useful not only for protecting what you have, but also for protecting your future,” Fleischman says.

Other options for dealing with debt

Defaulting and bankruptcy are not inevitable if you’re having trouble making debt payments — there are strategies that can help you get ahead.

Balance transfer credit card

If you have credit card debt on a card with a high APR, try transferring the balance to a card with an introductory 0 percent APR. This lets you pay down the balance without being charged any interest.

Most of these special APR offers last between 12 and 20 months, depending on the card’s terms. When the special offer is over, a regular interest rate will kick in, so it’s best to make as many payments as you can during the introductory period.

Debt consolidation loan

A debt consolidation loan is a personal loan that you use to pay off other debt, usually from credit cards. Debt consolidation loans typically have low fixed interest rates and terms lasting between one and seven years. Because debt consolidation loans typically have lower interest rates than credit cards, they’re a cheaper way to repay high-interest credit card balances.

Medical debt negotiation

If you have medical debt, you may be able to significantly decrease your monthly payments. Call the billing office, explain your financial situation and try to negotiate a lower monthly payment. Many hospitals offer relief plans and discounts for financial hardship. If you’re looking for assistance, you may also hire a medical bill negotiation company.

Student loan hardship options

If you’re struggling with student loan debt, know that bankruptcy won’t discharge that debt. However, there are options to make your payments more manageable.

Borrowers with federal student loans can choose to pursue deferment or forbearance for up to three years total. Depending on the type of student loans you have and the type of relief you choose, interest may still accrue during this time. Through Sept. 30, 2021, all federally owned student loans are automatically under forbearance with no interest accrual.

Another option for federal borrowers is to switch to an income-driven repayment plan with a loan forgiveness option.  This will extend your repayment timeline, but because the plan bases your student loan payments on your actual income, your monthly payment may be as low as $0.

If you have private student loans, you may still be eligible for deferment or forbearance options. This depends on the lender; if you’re facing financial hardship, call your lender and ask about your options.

Next steps

If you haven’t defaulted on your loans yet, you still have time to consider other options. Your first step should be to contact all of your lenders and bill providers and explain that you’re struggling with the monthly payments. Seeking out a lower rate, a deferment or a special payment plan may save you from default or bankruptcy in the future.

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