Declaring Bankruptcy: Pros and Cons

In 2015, almost 800,000 Americans (794,976 filed for personal bankruptcy and sought to have approximately $47 billion in debt forgiven, according to the U.S. bankruptcy courts. That equates to average household savings (in terms of future income paid to debtors of $59,000, and that amount does not include the substantial interest payments that would have accrued during the typically protracted payoff periods.

Ninety-nine percent of all personal bankruptcies are either Chapter 7 or Chapter 13 filings. The remaining one percent are Chapter 11 reorganization cases, for filers who have either too much income or too much debt to qualify for either of the other filings.

Slightly more than six out of ten personal filers sought a Chapter 7 Bankruptcy — a form of bankruptcy known as a liquidation. In this form, the filer surrenders all assets above the state-determined exemption level to a bankruptcy trustee in exchange for having all qualified debts discharged. Exemptions vary from state to state but typically include your house, vehicle, clothes, furniture, certain appliances, and tools, but do not include second cars, antiques, and collectibles, which the trustee will sell to pay off your debts.

The remaining four out of ten filers sought bankruptcy protection under Chapter 13 of the bankruptcy code. Designed for regular wage earners, chapter 13 bankruptcies are used primarily by filers who wish to avoid surrendering large assets that they otherwise would have had to forfeit in a Chapter 7 filing. Chapter 13 allows filers keep their assets in exchange for agreeing to apply a portion of their future income to a three to five-year debt repayment plan. The filer proposes a plan to the trustee for an amount equal to or greater than the value of the assets that would have been forfeited in Chapter 7. If the payment plan is accepted and completed, the filer receives a debt discharge similar to what a Chapter 7 filer would get.

Most unsecured debts can be discharged through bankruptcy. But student loans, child support obligations, unpaid criminal fines, and some personal income taxes are exempt.

Once a bankruptcy petition is filed, the court issues an “automatic stay” that prevents any further collection actions or lawsuits by creditors until the bankruptcy proceeding is concluded. This can take approximately three to four months in the case of a Chapter 7 filing, or up to five years for a successfully completed chapter 11 or 13 filing.

Bankruptcy was designed, historically, as a way to give consumers struggling with overwhelming debt the ability to discharge those obligations and get a fresh start financially. It comes with restrictions and costs. Individuals must wait six years between Chapter 7 filings and 180 days between filing for Chapter 13 bankruptcy relief. Those who file for bankruptcy suffer significant damage to their credit scores and to their future ability to obtain credit at favorable interest rates.

Notice of a bankruptcy filing appears immediately on the filer’s credit report and remains there for 10 years following a Chapter 7 filing and for seven years following a Chapter 13 filing. Debts discharged through bankruptcy are listed on credit reports for seven years after the date of discharge. Despite these adverse effects, the number of Americans filing for personal bankruptcy grew five-fold between 1980 and 2004, rising from 287,564 to slightly more than 1.5 million.

Chapter 7 Bankruptcy Restrictions

Prior to 2005, individuals seeking personal bankruptcy protection could elect to file for bankruptcy under the chapter of their choice. Most chose Chapter 7, because it provided fairly rapid debt discharge — in many cases within three or four months of filing. But the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005, a bill sponsored by and for banking interests, made it much harder for many individuals to get relief through Chapter 7.

The BAPCPA established a “means test” that pushed higher-earning bankruptcy filers into the less generous, more expensive, and more-difficult-to-complete chapter 13. Under the new law, your monthly income must be less than the state median income for a household of your size to qualify for chapter 7 relief.

BAPCPA clearly has shifted more people into chapter 13. After the BAPCPA went into effect, the average percentage of chapter 7 cases fell seven percent. While chapter 7 filings had accounted for 71 percent of personal bankruptcies filed prior to the passage of the BAPCPA, the number dropped to an average of 66.5 percent during the decade after.

Chapter 7 Pros

  • The court grants you an automatic stay upon filing for bankruptcy protection. All creditors and debt collectors must cease their efforts to collect until your case is over.
  • High success rate- When the paperwork is filed properly, 99 percent of petitioners get their qualified debts discharged.
  • Qualified unsecured debts (excluding student loans, child support, criminal fines and some state and federal taxes) can be completely discharged in chapter 7.

Chapter 7 Cons

  • You now must pass an income means test to qualify for a chapter 7 bankruptcy.
  • “Black marks” can significantly lower credit scores and make future credit difficult and expensive to obtain.
  • Filing requirements are complicated and if mishandled, can result in having the bankruptcy case dismissed and collection actions resumed. Filers are advised to hire legal representation.
  • Upfront fees- Lawyers typically charge $1,000 or more to handle chapter 7 bankruptcy cases, and court filing fees cost hundreds of dollars more.
  • You must wait at least six years before refiling for bankruptcy after filing a chapter 7 case.

Chapter 13 Pros

  • You get to keep all of your assets in a Chapter 13 filing — and thanks to the automatic stay, you may have time to catch up on your mortgage payments and avoid foreclosure.
  • If your case is dismissed early, you only have to wait 180 days to refile a chapter 13 proceeding.
  • Legal fees for a chapter 13 case can be included in the payment plan, giving the debtor the ability to spread those payments out for up to three to five years.
  • A chapter 13 case remains open to renegotiation throughout the term of the payment plan. If a debtor’s financial condition deteriorates, the option exists to attempt to revise the terms of the repayment plan to avoid default. If the debtor receives an unexpected windfall, he or she can prepay the balances owed and shorten the term.

Chapter 13 Cons

  • Your odds of getting long-term debt relief are poor. According to a 2007 report by the Wharton School, University of Pennsylvania, 20 percent of chapter 13 cases are dismissed without ever obtaining confirmation of even one payment plan. Less than 40 percent of debtors successfully complete their plans, which can last for up to five years, and get their debts discharged to receive a financial fresh start. For the rest, default means collection efforts resume based on the original payment terms.
  • The payoff plan must propose to pay at least as much as the value of non-exempt assets under a chapter 7 bankruptcy.
  • A chapter 13 case remains open to renegotiation throughout the term of the payment plan. If the debtor’s finances drastically improve (from an inheritance, for example) the trustee can attempt to force the debtor to agree to pay off more of the original debt, and at higher monthly payments.

Top Reasons People Declare Bankruptcy

In 2015, the Huffington Post Blog, “Simple. Thrifty. Living.” Reported on “The Top 10 Reasons People Go Bankrupt.” That year, 1.5 million U.S. adults filed for bankruptcy — almost double the 789,000 people who filed for personal bankruptcy in 2017, the most recent year for which we have data. The blog listed the reasons from most to least significant and item number 10 on the list was “bad budgeting/overspending.”

The financial emergencies that did the most damage were:

Medical Expenses

Nearly two-thirds (62 percent) of those who filed for bankruptcy cited unpaid medical bills as a major factor leading them down that path. Nearly three-quarters of that group (72 percent had health insurance, which suggests health insurance policies are no longer providing sufficient health-care coverage.

Reduced Income

Pay cuts and smaller than expected bonuses were frequently cited as key factors.

Job Loss

Even when the filer received a good severance package from an employer, a job loss could be devastating. Without income from a replacement job, the money quickly runs out. Other costs, such as the need to replace employer-subsidized health insurance with extremely expensive COBRA plans, tend to make matters worse.

Credit-Card Debt

About 170 million U.S. adult credit card owners have outstanding balances of about $4,800 each, for a combined credit card debt of slightly more than $1 trillion — the highest level ever. But it isn’t the spendthrifts among them who get dragged into bankruptcy. It’s people in trouble. Their difficulties typically begin when they use their credit cards to pay costs associated with personal emergencies. These include expenses from: illness and disability, job loss, large emergencies, and unexpected income reductions. In other words, they use their credit cards as lifelines to get them through crises, when they lacked the funds to pay for those costs out-of-pocket.

Divorce & Separation

Divorce is often accompanied by significant loss of income. A parent who pays child support may lose access to partially offsetting dependent-child tax deductions. Divorcing couples often must divide their assets and, if the spouses co-signed each other’s loans, they also can wind up splitting each other’s unpaid debts.

Unexpected Expenses

Car breakdowns, storm damage to homes — these are just a few of the possible emergency costs that can quickly become devastating for those with depleted savings. The picture today is bleak. According to CNN Money, 61 percent of Americans now say they can’t cover an unexpected expense of $1,000 or more, and 40 percent report they can’t even cover a $400 emergency.

Student loans

Student loan debt is responsible for approximately one percent of all U.S. bankruptcies, even though the loans themselves cannot be discharged.