When Your Best Option Is Bankruptcy
Bankruptcy doesn’t mean your world is coming to an end. In fact, it could end up actually being good for you.
Once you file for bankruptcy it stops wage garnishments, lawsuits and collection calls. Debt is erased. And despite things you may have heard, your credit scores can be helped by bankruptcy.
Scoring experts and credit bureaus frequently claim that the worst thing you could do to your scores is bankruptcy. Collections, charge-offs, repossessions, foreclosures – nothing else is able to drive down your scores as far and as quickly as a bankruptcy can.
However, that is not the entire story. A majority of people struggle with their debt for a very long time that by the time they finally file for bankruptcy their credit is shot already. And after they do file, typically their scores go up instead of down. Their score will increase even more if their debt gets erased – known as a “discharge” in bankruptcy court.
According to Jaromir Nosal, a Boston College assistant professor of economics, you will be much better off within a year. Nosal co-authored a study regarding the effects of bankruptcy for the New York Federal Reserve Bank. He says the recovery process is fairly rapid.
How soon and how much can your credit scores increase
Using Equifax credit bureau data, Philadelphia Federal Reserve Bank researchers found that the Equifax credit scores of bankruptcy filers dropped significantly during the 18 months prior to filing for bankruptcy and afterward rose steadily.
The findings included the following:
For an individual who filed Chapter 7, which in the most common kind of bankruptcy, in 2010 the average score was 538.2 on the 280 to 850 Equifax range (Generally scores in the low 600s and lower are considered to be poor). The average score was 620.3 at the time the bankruptcy cases of the filers were discharged, which is normally within six months.
Chapter 13, the other kind of bankruptcy, requires a 3 to 5 year repayment plan, which is not completed by a majority of people. (According to figures from the Justice Department and analyzed by American Bankruptcy Institute, of all of the Chapter 13’s that were filed from 2007 through 2013, half were dismissed while another 12 percent got converted into Chapter 7’s or another kind of bankruptcy). However, those who did and received a discharge, had their scores increase from 535.2 up to 620.8 according to researchers from the Philadelphia Fed.
A recent FICO study, from the company that developed what is considered to be the leading credit score, showed gains that were much smaller. The median credit scores for individuals who filed for bankruptcy from October 2008 through October 2010 increase from the 550’s prior to filing up to the 560’s afterwards according to senior director Ethan Dornhelm. (A majority of FICO scores are on a 300 to 850 scale.)
After two years of filing for bankruptcy, 28% of filers had 620 and higher scores. After four years, scores were 620 or higher for 48% and just 1% had a score over 700.
However, the study did not distinguish between Chapter 13 and Chapter 7, or between those individuals who received a discharge and those who did not. The results could have been skewed by those who had undischarged debt. So individuals with completed bankruptcies might have seen larger gains that what the median figures reflect, said Dornhelm.
Helping your credit score is just one reason.
There are factors to consider besides credit scores. Some of the other factors include the following:
Collection hell comes to an end: the study by Nosal found that after individuals fell behind seriously on their debts – with one account at least 120 day overdue – their financial problems had a tendency to get even worse. The percentage of individuals with court judgments or balances in collections increased.
By contrast, individuals who have filed for bankruptcy can benefit from the automatic stay which brings most collections to a halt, including wage garnishment and lawsuits. If the underlying debt gets erased, then garnishment and lawsuits come to an end.
Freed of certain debts: Many types of debts are wiped out by Chapter 7 bankruptcy, including the following:
- Some older tax debts
- Business debts
- Past-due utility bills
- Past-due rent
- Civil judgments (with the exception of fraud)
- Personal loans
- Medical bills
- Credit card debt
Some debts cannot be erased in bankruptcy, including tax debt and child support. Student loan may be at times, but it is quite rare. However, if you are unable to discharge some of your most troublesome discharge, having other debts erased can give you some needed room for being able to repay your remaining debts.
Better access to credit: Right after a bankruptcy it can be hard obtaining credit. However, Nosal’s study showed individuals who complete their bankruptcies are much more likely to be able to obtain lines of credit within 18 months compared to individuals who fell behind 120 or more at the same but do not file.
After bankruptcy, your credit limits most likely are going to be low. Also, your credit scores and access to credit won’t completely recover until your Chapter 7 bankruptcy doesn’t appear any longer on your credit reports in 10 years.
That is a very long time to be penalized. However, let’s get rid of the idea that people who are faced with bankruptcy are making a choice between getting their bills paid and not paying them.
When you should stop digging a hole you won’t be able to get out of
A majority of us feel obligation to pay the debts that we owe – if we are able to. However, the ship has usually sail by the time most individual realize they need to think about bankruptcy. They can try to keep chipping away at their debts that they might never be able to get repaid, and prolong the damage that their credit scores are suffering as well as diverting money that could be used for supporting themselves when they retire. Or they can realize the situation is impossible and get it dealt with so that they can move on.
If you are able to pay your bills, then of course you should do so. However, if you are struggling, then you should check out debt relief options. Bankruptcy might be your best option if you have consumer debt – like those listed above that may be erased – is more than half of what your income is, or if it will take your five years or long to get the debt paid off even if you take extreme austerity steps.
The following is what you really need to know:
It is important to have a bankruptcy attorney: Making a mistake is an easy thing to do with the complicated paperwork that is involved with a bankruptcy. One error could end up causing your case to get dismissed. If this occurs, then you won’t end up with any relief and your credit scores might still tank due to filing for bankruptcy.
Typically attorney prefer being paid upfront. Some pro bono services and legal aid are available, however frequently they are overwhelmed by the demand. You can call your area’s bankruptcy court if you are really broke to find out what the available resources are. Or you can contact your local bar association to see if they can direct you to lawyers who are willing to take a pro bono case on. Otherwise, you are going to have to come up with the money somehow.
- Raise money the smart way: Cut out any unnecessary expenses, if you have any still. Sell some of your things if you have anything to sell. Or if you are still trying to pay on your credit cards and other debts, you could stop and then use that money to pay for your attorney instead. Another potential option is borrowing money from family or friends. However,don’t open up any new credit accounts for borrowing money. That might be considered to be fraud. It can be problematic to work a second job if it raises your income over your area’s median, since that will complicate your filing. Speak with an attorney about what your options are; many of them offer a low-cost or free initial consultation.
- Make sure to not wait too long: There is a real misconception that individuals file bankruptcy as soon as there are signs of trouble or when there are other options available to them. However, in reality that isn’t true at all. Some people liquidate assets, like their retirement accounts, that bankruptcy could protect from creditors. Many people have a tendency to throw good money after the bad until it get to the point that they have used all of their money up and don’t have any for seeking relief.
This is why we recommend that debtor who are really over their heads consider bankruptcy first.
Nosal says that that worst thing is not being able to pay and not being able to go bankruptcy. That is when people truly suffer.