Generally speaking, people file for bankruptcy during extreme financial hardships: the inability to repay large debts, have outstanding mortgage payments or they are facing foreclosure. Bankruptcy can offer some people a clean financial slate, but should only be considered as a last resort in resolving loan debt. Here is everything you need to know before filing bankruptcy.
What Does Bankruptcy Mean?
Bankruptcy is a federal court proceeding where people liquidate their assets to pay off debts over time or sign up for a repayment plan. In some instances, those who file for bankruptcy may be released entirely from the liability of their debts. It’s essentially a second chance for people who are experiencing financial collapse.
What Are The Different Types of Bankruptcy?
There are 6 different types of bankruptcy, however, the most common types are Chapter 7 and Chapter 13, named after the federal court bankruptcy code.
Chapter 7 bankruptcy is sometimes referred to as liquidation bankruptcy because it usually requires you to cash in on some of your assets so you can pay off at least a portion of the debt you owe. Some assets are protected by state laws from liquidation, such as retirement accounts, portions of your home equity, and your car. Plus, creditors cannot target your wages once you’ve filed, so you’re protecting your future wages as well. Sometimes called straight bankruptcy, this is the most common type filed by individuals.
Chapter 13 bankruptcy is also known as wage earner’s bankruptcy. Rather than selling your property or assets, your debt is reconfigured so it can be paid off partially (or fully) over a 3-5 year period. While some debt may be discharged, certain types do not qualify: child support, alimony, student loans and certain tax obligations. If you cannot make the minimum payments on this type of arrangement, then creditors can start targeting your assets. Otherwise, this court-approved bankruptcy allows you to keep your home and additional assets.
Additional Options to Bankruptcy
Before declaring bankruptcy, it’s important to consider all available options. One option is to negotiate with your creditors directly. Many lenders have programs to help borrowers make payments or reconsider their current loan agreements. Some creditors reduce the overall amount or agree to lower payments over a longer period; they don’t always want to risk not receiving any form of payment, which can happen during bankruptcy.
Another option is loan forbearance, which is when payments are put on hold for a set period. Sometimes, there are loan modifications that allow you to change the terms of your loan, such as getting a different interest rate. Whatever your scenario is, make sure you exhaust all of your options before declaring bankruptcy.
What Happens If I Declare Bankruptcy?
When you declare bankruptcy, you are granted an automatic stay, which puts a block on your debt that creditors would normally collect. This prevents creditors from garnishing your wages or going after your other assets, which gives you time as the borrower to work out additional financial arrangements with both the courts and the creditor.
How bankruptcies work
Note that not everyone can declare bankruptcy. To avoid your case being dismissed, it’s important to follow all legal steps and requirements when you file. To begin, a credit counseling session is required to determine if you qualify for a bankruptcy petition certification.
Next, you will need to submit a bankruptcy petition and financial documentation that provides your income, assets and debt. To qualify for Chapter 7 bankruptcy, you will need to submit a means test form that determines whether your income is low enough. If it’s not, then Chapter 13 is usually the next best option. You can get these forms from the bankruptcy court.
Once you’ve filed, the trustee assigned to your case will arrange a meeting with applicable creditors who will ask you questions about your financial situation. Your case will go through a bankruptcy judge who will decide whether or not you are eligible. Most people don’t have to appear before a judge unless their case is uniquely complicated. One of the final steps you must complete before your debt is discharged is to take a debtor education course and earn a certificate. In terms of bankruptcy costs, there are attorneys fees and court costs you will owe, though some can be waived if you can’t afford to pay.
What happens to my credit score?
One of the biggest drawbacks of bankruptcy is the hit your credit score will take. If you have decent credit, your credit score will take quite a dip after bankruptcy—even from a 700 score to a 200 score. If you have a lower score to begin with, there may only be a 150-200 point drop. The credit effects vary from case to case, so the impact isn’t predictable until you file.
Some employers look at credit and financial history, so bankruptcy can also sometimes affect your future employment. Until the bankruptcy is removed from your records, it will affect your credit score and your credit history for up to 10 years with a Chapter 7 bankruptcy or up to 7 years with Chapter 13.
Other consequences have to do with your assets, especially if you’ve filed a Chapter 7 bankruptcy. Don’t hide any assets when you file; not only is it fraudulent, but it can get your entire case thrown out. Depending on the type of bankruptcy you file for, you’ll need to be prepared to give up certain luxury assets that can be used to pay off debt, as well as other non-exempt assets or property.
What happens to my loans after bankruptcy?
After completing the legal steps of filing and if your case is approved by a court judge, your debts will be discharged (Chapter 7) or your repayment plan will be approved (Chapter 13). A discharge in bankruptcy means that the loan is forgiven and the creditor can no longer attempt to collect payments or assets. A repayment plan means you're still responsible for your loan, but it’s been modified to be more manageable according to your finances.
Getting new loans can be tricky after bankruptcy, but there are some loans that don’t require high credit scores to qualify. FHA loans, for example, work with lower credit scores, so a history of bankruptcy or foreclosure is not necessarily a barrier to qualifying for an FHA loan.
The Bottom Line
Certain circumstances, such as unforeseen medical bills, can make it difficult to keep up with mounting debt. If you’ve found yourself facing the realities of bankruptcy, remember: bankruptcy isn’t going to define your financial future forever. You don’t want to file for bankruptcy lightly, but bankruptcy certainly isn’t an end-all-be-all. A history of bankruptcy doesn’t disqualify you from all future loans, nor does it stay on your financial record forever. You can rebuild your credit over time and still create the financial stability you want.
This article provides general information and does not contain legal advice. PennyMac Loan Services, LLC is not a law firm. For legal advice, please consult a lawyer.