When Bankruptcy Is the Best Option
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Bankruptcy isn’t the end of the world. It may even be good for you.
Bankruptcy stops collection calls, lawsuits and wage garnishments. It erases debt. And despite what you’ve heard, bankruptcy may help your credit scores.
Credit bureaus and scoring experts often say bankruptcy is the single worst thing you can do to your scores. Foreclosures, repossessions, charge-offs, collections — nothing else can drive your scores down as fast and far as a bankruptcy.
But that’s not the whole story. Most people struggle so long with their debt that their credit is already battered by the time they file for bankruptcy. And once they do, their scores typically rise, not fall. If the debt is erased — which is known in bankruptcy court as a “discharge” — scores go up even more.
“Within a year, you’re way better off,” says Jaromir Nosal, assistant professor of economics at Boston College, who co-authored a study for the Federal Reserve Bank of New York about the effects of bankruptcy. “It’s a pretty rapid rate of recovery.”
How much and how soon credit scores can rise
Using data from Equifax credit bureau, researchers at the Federal Reserve Bank of Philadelphia found that filers’ Equifax credit scores plunged in the 18 months before filing bankruptcy and rose steadily afterward.
Among the findings:
The average credit score for someone who filed Chapter 7, the most common type of bankruptcy, in 2010 was 538.2 on Equifax’s 280 to 850 range. (Scores in the low 600s and below are generally considered poor.) By the time the filers’ cases were discharged, usually within six months, their average score was 620.3.
The other type of bankruptcy, Chapter 13, requires a three- to five-year repayment plan, which most people don’t complete. (Half of Chapter 13s filed between 2007 and 2013 were dismissed, and an additional 12 percent were converted to Chapter 7s or other types of bankruptcy, according to an American Bankruptcy Institute analysis of Justice Department figures.) Those who did and got a discharge, though, saw their scores rise from 535.2 to 610.8, the Philadelphia Fed researchers found.
A recent study by FICO, the company that created the leading credit score, found much smaller gains. Median credit scores for people who filed for bankruptcy between October 2009 and October 2010 rose from the 550s before they filed to the 560s afterward, says Ethan Dornhelm, senior director for FICO’s scores and analytics group. (Most FICO scores are on a scale of 300 to 850.)
After two years, 28% of bankruptcy filers had scores of 620 and above. After four years, 48% had scores of 620 or above, and only 1% scored 700 or above.
But the FICO study didn’t distinguish between Chapter 7 vs Chapter 13, or between people who got a discharge and those who didn’t. Those with undischarged debt could be skewing the results. In other words, people with completed bankruptcies could have seen bigger gains than what’s reflected in the median figures, Dornhelm says.
Saving your credit score is only one reason
Credit scores aren’t the only factor to consider, of course. Some of the others:
An end to collection hell: Nosal’s study found that once people fell seriously behind on their debt — with at least one account 120 days overdue, for example — their financial troubles tended to get worse. Balances in collections and the percentage of people with court judgments grew.
By contrast, people who file for bankruptcy benefit from its “automatic stay,” which halts almost all collection efforts, including lawsuits and wage garnishment. If the underlying debt is erased, the lawsuits and garnishment end.
Freedom from certain debts: Chapter 7 bankruptcy wipes out many kinds of debt, including:
Credit card debt.
Civil judgments (except for fraud).
Past-due utility bills.
Some older tax debts.
Some debts, including child support and recent tax debt, can’t be erased in bankruptcy. Student loan debt can be, but it’s very rare. But if your most troublesome debt can’t be discharged, erasing other debts could give you the room you need to repay what remains.
Better access to credit: It can be difficult to get credit right after a bankruptcy. But Nosal’s study shows people who have completed bankruptcy are more likely to be granted new credit lines within 18 months than are people who fell 120 days or more overdue at the same time but didn’t file.
Your credit limits after bankruptcy are likely to be low, however, and your access to credit — like your credit scores — won’t recover completely until a Chapter 7 bankruptcy drops off your credit reports after 10 years.
That’s a long time in the penalty box. But let’s dispense with the idea that people facing bankruptcy are choosing between paying their bills and not paying their bills.
When to stop digging a hole you can't escape
Most of us feel we have a moral obligation to pay what we owe — if we can. But typically that ship has sailed by the time people realize they need to consider bankruptcy. They can continue trying to chip away at debts they may never be able to repay, prolonging the damage to their credit scores and diverting money they could use to support themselves in retirement. Or they can recognize an impossible situation, deal with it and move on.
If you can pay your bills, obviously you should. If you’re struggling, check out your options for debt relief. But bankruptcy may be the best option if your consumer debt — the kinds listed above that can be erased — equals more than half your income, or if it would take you five or more years to pay off that debt even with extreme austerity measures.
Here’s what you need to know:
You need a bankruptcy attorney: It’s easy to make a mistake in the complicated paperwork, and an error could cause your case to be dismissed. If that happens, you end up with no relief — but still have credit scores tanked by the bankruptcy filing.
Attorneys typically want to be paid upfront: There are some legal aid and pro bono services available, but they’re often overwhelmed by demand. If you’re really strapped, call the bankruptcy court in your area to find out what resources are available. Your local bar association may be able to direct you to attorneys willing to take on some pro bono cases. Otherwise, you’ll need to scrape up some cash to cover the cost of bankruptcy.
Raise cash the smart way: Trim unnecessary expenses, if you still have any. Sell stuff, if you’ve got anything to sell. If you’re still paying your credit cards and other consumer debt, you could stop and redirect the money to pay for an attorney. Another option is to borrow from friends and family. Don’t open new credit accounts to borrow the money, though, since that could be considered fraud. Working a second job can be problematic if you boost your income above the median for your area, since that complicates your filing. Discuss your options with an attorney; many offer a free or low-cost initial consultation.
Don’t wait too long: There’s a misconception that people file bankruptcy at the drop of a hat or when they still have other options. The reality for most is quite different. Some drain assets, such as their retirement accounts, that could have been protected from creditors in bankruptcy. People throw good money after bad until they have no money left to seek relief.
That’s why we advise debtors in over their heads to investigate bankruptcy first.
“The worst thing that can happen is not being able to go bankrupt and not being able to pay,” Nosal says. “That’s when people really suffer.”