Your Money, Your Future
Your Money, Your Future

For some consumers, bankruptcy is the solution to crushing debt

Key Points
  • Although student loan debt is difficult to discharge in bankruptcy, most other forms of consumer debt can be eliminated or reduced.
  • One of the biggest downsides to bankruptcy is the hit to your credit report, because it remains there for seven to 10 years.
  • Consulting with a bankruptcy attorney — often for free — can help you determine if there are other options for handling your debt.

For people facing crushing debt, the weight of carrying it can seem unbearable. As bills go unpaid and debt collectors start calling, one nagging question might loom large: Would bankruptcy fix this?

Depending on the type of debt you face and the rest of your financial picture, the answer could be yes.

"Many people who file for bankruptcy probably never thought they would," said Harvey Bezozi, a certified financial planner and certified public accountant at Your Financial Wizard in Boca Raton, Florida. "It's freeing, but it definitely can be traumatic to do it."

Photo by Geber86 via Getty Images

An estimated 733,000 businesses and individuals are expected to wipe out or reduce their debt through bankruptcy in fiscal year 2018, according to the U.S. Trustees Program. That's far below the peak of 1.5 million filings in 2010, yet up from an estimated 685,000 in 2017.

Meanwhile, overall household debt stood at more than $13 trillion at the end of 2017, according to the Federal Reserve. That includes $8.8 trillion in mortgages, $1.4 trillion in student loans, $1.2 trillion in car loans and more than $1 trillion in credit card debt.

While student loan debt currently is difficult to discharge in bankruptcy — you must prove undue hardship — most other consumer debt is fair game for either eliminating or negotiating a lower payback amount, depending on the specifics of your case.

Of course, getting to the point of actually filing the paperwork with the bankruptcy court means overcoming the emotions that accompany the decision.

"When people finally get to the point of coming to talk to me, it usually takes another six months for it to sink in that they have to file," said Cara O'Neill, a legal editor with Nolo who also is a bankruptcy and litigation attorney in Roseville, California.

She said there often is a triggering event — such as a lawsuit filed by a creditor — that makes people realize how much trouble they're in.

"People really don't want to have to go the bankruptcy route," O'Neill said. "They usually do everything they can to avoid it."

In fact, some end up tapping their retirement savings to stave off bankruptcy. Experts say this is a big no-no and often just delays the inevitable.

For starters, retirement assets — including 401(k) plans and individual retirement accounts that you own and contributed to — generally are protected in bankruptcy. (Inherited IRAs do not get the same protection.)

An exception to this broad rule applies to IRAs, both traditional and Roth: Up to a set amount per person — currently about $1.28 million — is safe from creditors. Any excess could go to pay off creditors. Additionally, if you already receive retirement income, that money is not necessarily protected in bankruptcy.

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Meanwhile, if you are younger than 59½ and turn to your retirement assets to pare down debt, you will pay an early-withdrawal penalty of 10 percent unless you meet one of a few exceptions. That's on top of paying ordinary income taxes on the distribution.

"The most significant thing to avoid is using retirement funds to pay back debt," O'Neill said. "If you can come out of bankruptcy without debt but with your retirement savings still intact, you'll be in a [more] stable financial place."

Filing options

There are several ways to file for bankruptcy. Most individuals typically choose between Chapter 7 and Chapter 13. Each has filing fees of a few hundred dollars, and enlisting an attorney can add $1,200 to about $3,500, depending on where you live and the complexity of your case.

"Most filers will stop paying the debts that are getting discharged and instead use that money to pay the costs of filing," O'Neill said.

It's also worth noting that while federal law governs bankruptcy, there are some differences among states regarding what property cannot be sold to pay off creditors. For instance, in some states, wedding rings up to a certain value are protected.

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Both Chapter 7 and 13 stop collection activity like calls from creditors or debt collectors, wage garnishments and, potentially, lawsuits from creditors. (Court judgments already in place are trickier to get rid of in bankruptcy.)

However, there are differences in who qualifies and how debt is treated in each option. Chapter 7 generally is for people who lack enough income to repay their debt and have little in the way of assets. It also is the most common way to file individual bankruptcy.

This approach quickly erases certain forms of debt, including from credit cards, medical bills and personal loans. It does not, however, necessarily stop your car from being repossessed or prevent home foreclosure, O'Neill said.

Chapter 13 generally gives you three to five years to pay back certain debt and keep the asset (i.e., house or car). It also prevents creditors from garnishing your wages or putting a levy on your bank account. For this filing option, you must have income, and your debt must be below a certain amount (about $1.5 million total).

For individuals with debt above that threshold, Chapter 11 — which is largely similar to Chapter 13 — might be the best choice. This is the least commonly used option for individuals.

Credit impact

The biggest downside of bankruptcy is the hit your credit report takes.

"You exchange not having that debt for having a bankruptcy on your report," said Ike Shulman, co-chair of the National Association of Consumer Bankruptcy Attorneys' legislative committee.

However, he said, many people who file for bankruptcy already have tarnished credit due to delinquent loans.

People don't file bankruptcy because it's an easy decision to come to. It's because they don't have other choices.
Ike Shulman
Co-chair of the National Association of Consumer Bankruptcy Attorneys' legislative committee

The filing remains on a credit report for seven to 10 years, although the impact decreases over time and your score will tick upward. In fact, most Chapter 7 filers can qualify for a mortgage loan four years later, O'Neill said.

Regardless of which bankruptcy approach you take, you should be prepared to provide detailed information on your financial life to the court. That includes tax returns, bank statements, pay stubs and the like.

Keep in mind, too, that having an initial consult with a bankruptcy attorney often is free. They also might have suggestions for handling your debt that does not involve bankruptcy.

"No one wants to acknowledge they can't handle their bills," Shulman said. "People don't file bankruptcy because it's an easy decision to come to. It's because they don't have other choices."