When should I file for bankruptcy?

Key takeaways

• Chapter 7 and Chapter 13 bankruptcy are common options for individuals with unmanageable debt.

• Bankruptcy should only be considered as a last resort after credit counseling. 

• Alternatives may not be accessible, so consult a lawyer to determine if bankruptcy is the best route for you.

Bankruptcy is designed to be used as a last resort when you have exhausted all other options. Depending on the bankruptcy option you choose, you may be able to eliminate all or some of your debt — or restructure it so monthly payments are within your budget.

However, it is not without consequence. Bankruptcy stays on your credit report for years. This can make it difficult to build your creditworthiness back up and access new credit in the future.

If you are considering bankruptcy, speak with an attorney. They can guide you to the best time to file and ensure you are following the right steps to complete the process.

When and how to file, and what to expect

The two most common types of bankruptcy are Chapter 7 and Chapter 13. Chapter 7 eliminates all or most of your debt once your personal property has been sold. Chapter 13 modifies your current debt payments to make them more affordable based on your income.

Both should only be sought as a last resort option, and other methods of debt relief should be checked before filing. Consider credit counseling first, and if you do decide to move forward with bankruptcy, it may be worthwhile to hire an attorney. They will be able to walk you through the process and ensure everything is submitted correctly.

Filing Chapter 7

Chapter 7 bankruptcy is the quicker option, but it involves more sacrifice. While it is usually completed or discharged in four to six months, you will have to sell all nonexempt assets.

To qualify, your income will need to be less than your state’s median income. If you pass this means test, you will be allowed to file.

Filing involves submitting documentation on income and debts as well as a list of assets. You will also need to provide copies of your recent tax returns and a certificate of credit counseling. Other documentation may be required as well, though it will depend on your employment status and total wealth.

Not all debt is not discharged with Chapter 7. Taxes, student loans, secured debt, child support and alimony usually cannot be erased through bankruptcy.

Filing Chapter 13

Chapter 13 will leave you with a payment plan that’s up to three or five years. When you file, you turn over the management of your accounts to the court. It will determine how much you can pay your creditors each month, and your appointed trustee will forward payments on your behalf.

There is no means test for Chapter 13, but you will need a combined total of less than $2.75 million in secured and unsecured debts to qualify. Like Chapter 7, you will need to provide information on your income and current debts. You will also need to file a certificate of credit counseling.

Unlike Chapter 7, you will not risk losing your home if you own it. It is a much lengthier process, but at the end of it, nearly all debt can be discharged.

How does bankruptcy affect your credit?

Both Chapter 7 and Chapter 13 will bring your credit score down significantly. If you start out with a credit score of 700 or higher, point losses of 200 or more are not uncommon with a bankruptcy. If your score is 680 or less, you are probably looking at a loss of 130 to 150 points.

You can build your score by paying your new bills on time, every time and watching the use of any credit you still have access to.

Disadvantages of filing for bankruptcy

The effects of a bankruptcy often go beyond your credit score, though that will also take a long time to repair, regardless of the type of credit repair you choose.

• Could be a red flag to potential landlords and employers.

• May impact your insurance rates.

• Remains on your credit report for seven to 10 years.

You also have a limited ability to file. Chapter 13 can only be completed once every two years, and Chapter 7 can only be completed once every eight years.

Advantages of filing for bankruptcy

While there are credit risks related to filing for bankruptcy, this process can also be a life saver.

• Eliminates or discharges multiple unsecured debts.

• Chapter 13 creates a more affordable monthly payment.

• Gives you the financial freedom to begin saving.

• May improve your credit and finances in the long run.

Bankruptcy alternatives

Bankruptcy should be used as a last resort, and some alternatives, like credit counseling, may be necessary before you can file. You may also want to look into professional debt relief options, including reputable debt relief companies.

Contact a credit counselor

When you file for Chapter 7 or Chapter 13 bankruptcy, you will need to attend credit counseling. Your credit counselor will go over your options and help create a plan. Check the National Foundation for Credit Counseling to find a qualified nonprofit agency.

Even if you don’t pursue credit counseling, a credit counselor can create a debt management plan for you. Similar to Chapter 13, a debt management plan is a systematic approach to paying off unsecured debt in three to five years.

A debt management plan will have a less extreme impact on your credit score, and you will have ongoing support from a certified professional if you need to change payments, negotiate with your creditors or can’t make a payment.

Tighten your budget

To help you be sure, review what you owe and your current income. A bare-bones budget may help you reorganize your priorities and come up with the funds to get yourself out of debt

If there isn’t much wiggle room, you may need to consider selling some items or another source of income. It may not be ideal, but these can be short-term ways to make ends meet while you work through credit counseling.

Ask your creditors for relief

Reach out to your creditors and see if you can negotiate better terms or settle for less than you owe. They may not be willing to — and that’s okay. Be clear about your ability to repay, and even if you default you may at least be able to avoid collections or defer payments.

Because bankruptcy will discharge your debts, your creditors may consider settling for less to ensure payment. This isn’t always the case, however, and it will largely depend on your financial situation.

Debt consolidation

Some debt relief companies offer debt consolidation, but you can also take out a debt consolidation loan on your own. If you’re considering bankruptcy, you’ll likely need to look for a debt consolidation loan for bad credit.

Regardless of the avenue you go down, shop around for the best debt consolidation loan rates before applying. You’ll also want to be sure the payment is affordable, otherwise you may just be delaying more intensive debt relief.

The bottom line

Filing for bankruptcy should be a last resort, but it can help. Chapter 7 requires a means test but will eliminate most of your debt, and you may see a rebound in your credit score in just a few years. Chapter 13 helps you reorganize your debt and make payments more manageable, though it will take significantly longer to complete.

If you decide to file, consider working with an attorney to avoid complications or mistakes that could cost you.