Over the last several years I’ve spoken to a lot of people, and some of their stories are heart breaking. Several have had crippling amounts of debt, and it was difficult to see a reasonable path forward for them. In all of these cases, they felt morally bound to pay off their debts, which is a testament to their character. But there are times when it may make sense to wipe the slate clean.
In our culture, bankruptcy is still considered a terrible thing. If it weren’t, we would have all sorts of other issues, like higher interest rates and a much harder time getting credit. However, the tool is there for a reason, and if you are struggling to make your debt payments and keep food on the table, it may be worth considering.
First, what is bankruptcy? Bankruptcy is a legal process that either discharges or reorganizes your debt, depending on the form you use. Chapter 7 bankruptcy eliminates your non-exempt debt but at the cost of giving up most of the valuable things you own. Chapter 13 essentially reorganizes your debt, allowing you to pay it off over three to five years. Depending on the type of debt you hold, you may wind up paying less than the total outstanding amount.
Not all debt can be eliminated with bankruptcy. Student loans are a big category where filing bankruptcy won’t do you any good, except in rare cases. Others include tax debt and spousal or child support. There are 19 categories of debt that cannot be discharged in bankruptcy. You can find a summary at NOLO.com.
However, medical debt, credit card debt and several others can be discharged or made more manageable by filing for bankruptcy. These types of debt can mount quickly if you have a serious illness or injury and/or find yourself out of work.
If you have little in the way of valuable property, Chapter 7 bankruptcy may be a reasonable choice. You will turn over most of what you do own to the courts, and it will be sold to pay as much of your debt as possible. But there are exceptions. Your personal belongings like clothing and furniture are mostly exempt. A vehicle that is required to get you to work, and any tools required for your trade are also likely exempt. In some cases, your home equity may be excluded as long as you make the mortgage payments. Savings in tax-deferred retirement accounts, like 401(k)s and IRAs are exempt.
For those with a steady income that will allow you to make payments on your debt, Chapter 13 may be a better choice. You will not have to give up what you do own, and your debt will be restructured and consolidated into a single payment which you will be better able to afford. When the payment period is over, you can be mostly back on your feet.
Bankruptcy is not a cure-all. It has downsides, and should only be considered if you are committed to turning your finances around. It will devastate your credit score initially, though over time that will recover. You will not be able to get additional credit for a year or two, but eventually that will open up for you too.
If your debt is suffocating you, it may be time to think about getting some relief. Obviously, its much better to avoid a mess like this in the first place, but that doesn’t help once you’re there. And sometimes stuff happens that makes it hard to avoid. Bankruptcy is not the first tool that you should reach for. But it is a reasonable last resort.
For a comprehensive, step-by-step guide to building your own financial plan, pick up my book, Save Yourself; Your Guide to Saving for Retirement and Building Financial Security. It is now available on Amazon.