What Are the Pros and Cons of Filing Bankruptcy?

Bankruptcy provides a legal pathway for individuals or businesses to manage overwhelming debt. This formal process allows debtors to either discharge certain debts, meaning they are legally forgiven, or to reorganize their financial obligations under court supervision. It aims to offer a fresh financial start, preventing creditors from taking collection actions and providing a structured approach to debt resolution.

Types of Bankruptcy and Eligibility

Chapter 7 and Chapter 13 are the most common types of personal bankruptcy for individuals. Chapter 7, often referred to as liquidation bankruptcy, involves the sale of a debtor’s non-exempt assets to repay creditors. Eligibility for Chapter 7 is determined by a “means test,” which compares an individual’s income to the median income in their state. If the income is below the median, they generally qualify.

If an individual’s income exceeds the median, further calculations determine if they have sufficient disposable income to repay a portion of their debts. Debtors must also complete credit counseling from an approved agency within 180 days before filing.

Chapter 13, known as reorganization bankruptcy, allows individuals with regular income to create a repayment plan to pay back all or a portion of their debts over three to five years. Unlike Chapter 7, Chapter 13 does not require the liquidation of assets, allowing debtors to retain their property. Eligibility for Chapter 13 depends on having a stable income source and not exceeding certain debt limits for secured and unsecured debts.

As of early 2024, the unsecured debt limit for Chapter 13 is approximately $465,275, and the secured debt limit is around $1,395,875. Individuals who have completed a Chapter 7 discharge within the past eight years or a Chapter 13 discharge within the past two years may face restrictions on filing another bankruptcy. Both chapters require debtors to file financial documents, including income, expenses, assets, and liabilities, with the court.

Immediate Financial Outcomes

Filing for bankruptcy brings immediate financial effects, primarily concerning existing debts and assets. The “automatic stay” takes effect immediately upon filing. This legal injunction temporarily halts most collection actions by creditors, including lawsuits, wage garnishments, repossessions, and foreclosure proceedings.

Debt Discharge

The primary advantage of bankruptcy for many filers is the discharge of certain debts. Chapter 7 typically discharges most unsecured debts, such as credit card balances, medical bills, personal loans, and past-due utility bills. This means the debtor is no longer legally obligated to pay these debts.

However, not all debts are dischargeable in bankruptcy. These include most student loan debt, unless the debtor can prove “undue hardship.” Other non-dischargeable debts include child support and alimony obligations, recent tax debts, and debts incurred through fraud or willful and malicious injury.

Debts for government fines or penalties, and certain debts from a divorce settlement that are not alimony or child support, are also non-dischargeable. Secured debts, such as mortgages or car loans, are not discharged if the debtor wishes to keep the property, as the lien remains. For these, the debtor must continue making payments or surrender the collateral.

Asset Treatment

Asset treatment differs between Chapter 7 and Chapter 13 bankruptcy. In Chapter 7, a trustee is appointed to oversee the debtor’s assets and determine which are “exempt” from liquidation and which are “non-exempt.” Exempt assets are protected by law and cannot be sold to pay creditors.

Common exemptions include a portion of home equity (homestead exemption), a certain value in a vehicle, household goods, tools of the trade, and retirement accounts like 401(k)s and IRAs. Non-exempt assets, such as a second home, luxury items, or excessive cash, may be sold by the trustee to distribute proceeds to creditors. The specific exemption amounts vary, often determined by state or federal law.

In contrast, Chapter 13 bankruptcy allows debtors to retain all of their assets, whether exempt or non-exempt. Instead of liquidation, the debtor proposes a repayment plan to the court, outlining how they will pay creditors over a three to five-year period. The plan must ensure that unsecured creditors receive at least as much as they would have received in a Chapter 7 liquidation.

While a debtor keeps assets in Chapter 13, the value of non-exempt assets influences the minimum amount they must pay back to unsecured creditors through their plan. Home equity and vehicle values are factored into this calculation, impacting the feasibility and structure of the repayment plan.

Long-Term Financial Implications

Filing for bankruptcy has enduring consequences, particularly for an individual’s credit standing and future financial opportunities. While it offers immediate relief from debt, the impact on credit is a significant concern after discharge.

Credit Impact

Bankruptcy has a negative effect on a credit score, often causing it to drop significantly. A Chapter 7 bankruptcy remains on a credit report for up to 10 years from the filing date. A Chapter 13 bankruptcy, which involves a repayment plan, stays on a credit report for up to 7 years from the filing date.

This presence on a credit report can make it challenging to obtain new credit, such as mortgages, car loans, or credit cards, in the years following the bankruptcy discharge. Lenders view bankruptcy filers as high-risk borrowers, leading to higher interest rates, stricter terms, or denial of credit applications. Waiting periods are common before qualifying for major loans.

Future Financial Management

Despite initial challenges, rebuilding credit and achieving financial stability after bankruptcy is possible with disciplined financial management. The first step involves securing new lines of credit, such as secured credit cards or small personal loans from lenders specializing in post-bankruptcy credit building. These types of credit require collateral or a deposit, reducing the risk for the lender.

Making timely payments on all new and existing obligations is important, as payment history is a dominant factor in credit scoring. Developing and adhering to a realistic budget helps manage expenses, avoid new debt, and build an emergency savings fund. Over time, consistent positive financial behavior demonstrates renewed creditworthiness, allowing for gradual access to more favorable lending terms and a stronger financial foundation.