Knowing When to Hit Ctrl-Alt-Delete: The Bankruptcy Post

Knowing When to Hit Ctrl-Alt-Delete: The Bankruptcy Post

First, let me just say that I’m no financial expert and I’ve never had to declare bankruptcy. The following is just a collection of my research, thoughts, and opinions.

Now that we’re clear, on with it…

On March 9 2020, the outbreak of the Covid-19 virus caused a rapid drop in the financial markets. So rapid, that when S&P 500 fell by 7.79% it triggered an automatic 15-minute pause on all trading–a safeguard put in place after the 1987 crash to prevent panic-selling and stave off a catastrophic collapse.

This idea of a financial circuit breaker got me thinking about what the conditions were in my own financial life that would trigger a halt–I’m talking of course about bankruptcy.

If I’ve learned anything about debt it’s that it sneaks up quietly. It’s easy to adjust to new normals like not paying the Visa off in full or being a few days late on the electric bill while you wait for your paycheck. And then maybe a few “catastrophe’s” happen like a vet bill or car accident. Oh well, I’ll pay that off eventually.

And sometimes there is true disaster–a flood, a car accident, or as we’re learning in 2020 a pandemic that puts everyone’s financial life in jeopardy.

So at what point should someone say, “Stop”? Taking emotion out of it, when does it make more financial sense to declare bankruptcy than try to chip away at your debt by yourself?

It’s a worthwhile exercise to prepare for the worst before it happens. So in this post, I’m going to examine three central questions:

  1. What is bankruptcy and what options are there?
  2. What are short and long-term implications?
  3. What conditions would have to be present to make bankruptcy an option?

What is bankruptcy?

In short, bankruptcy is a tool when you become insolvent, which means unable to make payments towards your debt. It is a legal process that you, the debtor, initiate and will eliminate or reorganize your debt so you can financially recover.

Insolvency and bankruptcy are often used interchangeably, but they have different meanings. Insolvency is a type of financial distress. Bankruptcy is a legal process.

What bankruptcy is not

Bankruptcy is not total debt forgiveness. Depending on what “Chapter” you file under, only certain debt is available for relief (more on that later). By declaring bankruptcy, you are in essence telling your lenders, “Given my current state of affairs, I have no way of paying you back.”

It therefore becomes in the lenders’ best interest to work with you on a new plan so that they can still recoup some of their money.

Bankruptcy also doesn’t mean you have to give up everything you own. Part of the idea behind bankruptcy is that it allows you to keep essential assets like your house and car while you work on your debt.

Bankruptcy Options and How They work

The process of filing for bankruptcy differs depending on what classification you apply for.

There are six types of bankruptcy in the United States: Chapters 7, 9, 11, 12, 13, and 15. Four of those (Chapters 7, 11, 12, and 13) are available to individuals.

Briefly, What’s The Difference?

Chapter 7

Assets are sold to pay back what you can and eligible debts are wiped clean.

Chapter 11

Usually for high asset individuals or businesses.

Chapter 12

Similar to Chapter 13 but specific to farmers and fishermen.

Chapter 13

This is a restructuring of debt for people that have enough disposable income to repay most of the debt. Also known as Wage Earner’s Bankruptcy.

Most individuals in the U.S. are going to file under Chapter 7 or Chapter 13. Here’s a quick snapshot of them before we move on:

Chapter 7 Bankruptcy: This is a relatively quick (3-6months) process that involves forgiveness of all of your unsecured debt (personal loans, medical bills, credit cards, etc), making it an attractive option if you qualify. However, it does not wipe out all kinds of debt, and you must sell off nonexempt assets (if you have any) to put towards your outstanding debt.

Chapter 13 Bankruptcy: This a longer (3-5 years) process that involves a restructuring of your debt. With this option, you arrange a payment plan and make monthly payments to a trustee, who then disperses those funds to your various creditors. Chapter 13 doesn’t require you to liquidate any assets and can prevent a foreclosure on your home.

Different kinds of debt

It’s important to understand how debts are classified.

Priority debt: This is debt that is granted special status under bankruptcy law. Consider it “first in line” to get paid such as taxes, alimony, and child support.

Secured debt: This is debt that is “secured” by the underlying property the debt was used for like a house or car. The security comes from the lender being able to take back or sell-off the asset to recoup their money if the debtor doesn’t make payments.

Unsecure debt: This is debt for which the lender has no special rights and is not tied to anything physical, like consumer debt, personal debt, and medical bills.

Can you choose what chapter to file under?

Technically yes, but the chapter you file under will most likely be determined by your financial circumstances.

Creditors can sometimes force individuals into Chapter 7 bankruptcy, forcing you to sell off your assets.

Chapter 7

Declaring Chapter 7 bankruptcy isn’t available for everyone to just sign up for.

To qualify, you must pass a Means Test, which examines all aspects of your financial life (income, assets, expenses, etc) and determines if you have enough disposable income to put towards your debt.

The first part of the Means Test is to see whether your income from the prevoius six months is less than the median income of the state you’re filing in. If it is, the Chapter 7 filing usually proceeds 4.

If not, the courts will take a detailed look at your financial life and judge whether or not you can repay your debt on your own. If they find you have enough monthly income to pay, your case is either dismissed or converts to a Chapter 13 filing if you choose to pursue that path.

95.5% of all applicants pass the Means Test.6

You can not apply for Chapter 7 if:

  • You’ve had a bankruptcy case dismissed in the previous 180 days because of failure to comply with orders of the court. 2
  • You have completed a previous Chapter 7 within the past eight years.5

Chapter 13

You are eligible for Chapter 13 bankruptcy if:

  • You are employed or have regular income
  • Your unsecured debts are less than $394,725 and
  • Secured debts are less than $1,184,200 3

You can not apply for Chapter 13 if:

  • You’ve had a bankruptcy case dismissed in the previous 180 days because of failure to comply with orders of the court 3
  • You’ve completed a previous Chapter 13 within the last six years.

What debt gets forgiven?

Chapter 7

Generally, all unsecure debt gets forgiven in Chapter 7 bankruptcy, but that doesn’t mean everything gets taken off the book.

Debt that gets forgiven

All unsecured debt:

  • Credit cards
  • Medical bills
  • Lines of credit
  • Personal loans
  • Past due utility bills
  • Bounced checks
  • Car accident claims
  • Past rent due
  • Civil court judgments
  • Some past due taxes
  • Attorney fees (except child support and alimony)
  • Veterans assistance loans
Debt that doesn’t get forgiven
  • Mortgage
  • Car loan
  • Student loans
  • Money obtained or owing as a result of crime

Chapter 13

Debt that gets forgiven

In Chapter 13 bankruptcy, any unsecure debt you can’t afford under your new payment plan, as long as creditors receive at least as much as they would otherwise receive if your assets were liquidated, will be forgiven. 3

Debt that doesn’t get forgiven

Most of your debt under Chapter 13 bankruptcy won’t be forgiven in the traditional sense, it will simply be reorganized/restructured under a 3-5 year repayment plan.

But not all debt is treated equally in Chapter 13. 8

  • Priority debt: This needs to be paid back in full and includes things like back taxes, alimony, and child support.
  • Secure debt: You must pay back loans on secure assets. Missed mortgage payments must be included in the 3-5 year plan although you can still make regular mortgage payments over the long term. If you want to keep your car, that will be handling depending on your situation and your jurisdiction.
  • Unsecure debt: If you have enough disposable income left over, this will need to be included as well.

Which is better, Chapter 7 or Chapter 13?

It really depends on your situation, and again, you may not really have an option. Both have their benefits and drawbacks. But generally speaking:

Benefits of Chapter 7 over Chapter 13
  • Most debt will be forgiven
  • Faster process
Benefits of Chapter 13 over Chapter 7
  • You can preserve your assets
  • Prevent foreclosure on your home
  • Less impact on credit and you may still be allowed to borrow

“The debtor may still lose the home if the mortgage company completes the foreclosure sale under state law before the debtor files the petition.” – US Bankruptcy Code 2

The general bankruptcy process

The Chapter 7 Bankruptcy Process

In general, here’s how it goes:

  1. Pass the Means Test, which examines all of you assets, liabilities, expenses, and income. It’s important to know that you must qualify for Chapter 7 bankruptcy. If you make too much money, you have to look at other options like Chapter 13.
  2. Complete credit counseling within 180 days of filing. This is done for your education and protection to ensure that filing for bankruptcy is your only option.
  3. File your paperwork. This puts an automatic hold on all of your debts, meaning creditors can not sue you or seize assets for non-payment.
  4. Pay the filing fee of $335.
  5. The court appoints a trustee to take over your case and a meeting of creditors is held between you and your creditors where they get to ask you about your finances.
  6. Your eligibility for Chapter 7 bankruptcy is determined.
  7. Nonexempt property is assessed and sold by the trustee.
  8. A financial education course must be completed.
  9. Your case is discharged and all eligible debt is forgiven.
Sale of assets

The seizure and sale of your assets does not mean you’re left penniless and living on the street. But know that by filing Chapter 7 bankruptcy, you risk losing some of your possessions. After all it doesn’t make sense to get to keep your boat if you owe people money.

Assets which are exempt differ by state, but some states adhere to the federal guidelines. Some of these exemptions include:

  • Home: Up to $25,150 in equity (if it is your primary residence).
  • Vehicle: Up to $3,775 in equity
  • Household goods: $12,625 (furniture, appliances, clothing, etc)
  • Jewelry: $1600
  • Health aids: Full value
  • Retirement accounts (IRA/Roth IRA): Capped at $1,283,025
  • Education IRA: Full value
  • Wildcard exemption: $1,250 plus up to $11,850 of any household exemptions you didn’t use

Again, your state may differ slightly. These are just some of the federal guidelines.

The Chapter 13 Process

In general, here’s how it works:

  1. You file a petition with the bankruptcy court in your area.
  2. You must then disclose your full financial status including assets, liabilities, income, and expenses.
  3. You must submit your most recent tax return.
  4. Complete and file a certificate of credit counseling and your proposed debt repayment plan.
  5. Pay the case filing fee ($235) and administrative fee ($75).
  6. Once filed there is an automatic hold on most collection actions against you and your property (including foreclosure).
  7. Payments to the trustee need to be made within 30 days of filing (even if the repayment plan has not yet been approved).
  8. Between 21 and 50 days later, a trustee holds a meeting between you and your creditors.
  9. A court hearing is held to determine and approve the repayment plan.
  10. Take a second financial education course, make your payments, and receive your discharge once your payment plan is complete.

Coming up with your payment plan in Chapter 13 is complex and depends on your unique situation.

How much does it cost to declare bankruptcy?

Chapter 7

The cost of filing depends on whether or not you use a lawyer. Just know that filing on your own will increase the chance that something will be done incorrectly, which could get your case thrown out.

Filing on your own

The filing fees are $335 and there is an option to pay in installments. This must be paid within 120 days of filing or the case will be dismissed.

You can petition the court to have the fee waived, but you must show that you are unable to to pay the fee in installments.

Filing with a lawyer

Working with a bankruptcy lawyer will add to your costs. The average lawyer fee for a Chapter 7 case is around $1000 but varies by state. 7 However, legal aid offices may provide free advice to low income individuals and some lawyers may take your case pro bono.

Chapter 13

Again, the cost of filing depends on whether or not you use a lawyer. In either case you will have to pay a monthly administration fee.

Monthly administration fee (applies to every case)

Up to 10% of your payment will be to the trustee who handles your case. 8

Filing on your own

The total filing fees are $310 and there is an option to pay in installments. However, unlike Chapter 7, this is non-negotiable and can not be waived.

Filing with a lawyer

Using a lawyer is generally more expensive for Chapter 13 bankruptcy compared to Chapter 7. The average cost is around $2500, although this will vary by state.7

Life after bankruptcy

How does bankruptcy affect your credit score?

Declaring bankruptcy can have a significant affect on your credit score, as it signals to lenders that you are a credit risk. But let’s be honest, if you’re at the point where declaring bankruptcy makes sense, your credit score is probably pretty low anyway.

However, this doesn’t mean bankruptcy will haunt you forever. Your credit will probably rehabilitate quicker than you think as you establish a responsible and reliable history of spending.

How Fast Does Credit Recover?

Here are some answers I found on Reddit:

  • “Got a secured credit card right after I filed in 2013. A car loan couple years after and a house in 2016. You have to wait at least 2 years for a home mortgage. Use that time to recover your credit and save money.” Thread here.
  • “I filed chapter 7 in 2009 and I was able to buy my first home in 2013. So it doesnt take super long if you’re diligent about it. I got myself a secured card 1 year after and I got a cosigner on a used car loan 2 years later. 4 years after filing I was in the 650s.” Thread here
  • “My fiance had to file chap 7. He was approved for $500 Capitol One card, not secured about 6 months after. He grew his score to 650ish in one year, and we were able to buy a house a year and a week after it was discharged.” Thread here.

Chapter 7

Because a Chapter 7 bankruptcy means your creditors won’t get paid, it has a greater and more long-lasting effect on your credit score compared to Chapter 13.

The degree to which it will immediately drop your score depends on the amount of debt that was discharged and the status of your accounts prior to declaring. The bankruptcy filing will exist on your credit report for 10 years. 3

Chapter 13

Since most of your debt will eventually be paid back, declaring Chapter 13 bankruptcy will have a less severe but still significant impact on your credit score. A Chapter 13 discharge will remain on your credit report for 7 years. 3

Rebuilding credit after bankruptcy

Your credit score will have taken a significant hit from bankruptcy. Here are some things you can do to start the process of repair.

  • Pay your bills before they’re due. This will show creditors you’re budgeting and managing your money effectively.
  • Apply for a secured credit card. You’ll have to front the money as a deposit on the card, but it will help rebuild your credit and allow you the convenience of shopping online.
  • Monitor your credit score. Make sure the positive actions you’re taking are reflected in an improving score.
  • Don’t apply for too much credit. If you need some credit, by all means go for it. But be careful. Trying to apply for too much, too frequently can negatively impact your score. Wait a few months in between applications.

Are you allowed to borrow money after bankruptcy?

Chapter 7

After your case is discharged, technically, you’re on your own and free to get credit. It just may not be easy due to the hit on your credit score.

Chapter 13

While in the process of making your payments, you will not be allowed to take on any new debt without first clearing it with your trustee, as additional debt may compromise your ability to adhere to the plan. 3

Should you declare bankruptcy?

This is the big question. But first, it’s important to understand a few things.

Although bankruptcy is essentially a math and numbers issue, it’s also a highly emotional one. Right or wrong, there’s a stigma attached to bankruptcy. In a society that praises resourcefulness, intelligence, and cunning, there can be shame in throwing up your hands, admitting defeat, and begging for help. I’d be lying if I said my pride wouldn’t be damaged if I ever had to pursue this path.

But how we feel about money often gets in the way of making sound, practical decisions with it.

Bankruptcy is a financial tool. Nothing more. It exists because a society of people drowning in debt, and lenders not getting paid, can not be a flourishing one. Bankruptcy gives people a path to repairing their financial life while preserving essential assets.

This a good New York Times article from 2009 which discusses how peoples’ fear and shame around bankruptcy prevent them from filing when they should, which is often long before they’ve lost everything.

Signals that bankruptcy might be an option

So back to the original question: What would it take for me to hit the pause button and trigger bankruptcy proceedings?

It’s tempting to be reductionist and try to boil it down to one single number like a debt-to-income ratio, but I don’t think such a drastic personal and financial decision should be pre-determined so inflexibly.

But I do think there is value in establishing some sort of system of checks on the system–some way of sounding the alarm so I don’t get caught flat-footed or unprepared. I would hate to let my ego prevent me from making a rational choice when it comes to something like this.

So here is a series of questions I (and you) can ask, if my financial situation ever worsens:

  1. Is my debt-to-income ratio more than 50%?
  2. Am I only make the minimum monthly payments on my debt?
  3. Am I taking on additional debt to fund essential costs of living?
  4. Am I frequently behind on bill payments or receive collection calls?
  5. Do I have large amounts of unsecure debt?
  6. Would you be unable to pay off my debt within 5 years?

If the answer to any one of these questions is ‘yes’ AND I’ve made all of the reasonable cuts in expenses I can think of, I think it’s worth at least putting bankruptcy on the radar.


References

1. Should You File for Bankruptcy? – Investopedia

2. Section 109 – Who may be a debtor – US Bankruptcy Code

3. Chapter 13 Bankruptcy Basics – US Courts

4. Bankruptcy Means Test: Am I Eligible for Chapter 7 Bankruptcy? – Debt.org

5. Filing for Bankruptcy More Than Once – Lawyers.com

6. Chapter 7 Bankruptcy – Debt.org

7. The Cost Of Bankruptcy – Debt.org

8. Debts You Must Pay Back in Your Chapter 13 Bankruptcy Plan – Alllaw.com

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