Posted by Income Taxes and Bookkeeping LLC

When To Consider Bankruptcy

When To Consider Bankruptcy

Bankruptcy may make sense if you cannot pay off your debts by covering retirement, food, and shelter obligations.

Bankruptcy is definitely not the end of the world. It could be good for you too.

Bankruptcy stops collection calls, lawsuits, and wage garnishments. It helps cancel the bad debt, and despite what you've heard, bankruptcy can help you improve your credit score.

Credit bureaus and scoring experts often claim that bankruptcy is the worst thing you can do to your score. Repossessions, foreclosures, cancellations, collections - nothing else can bring your score down so quickly as a bankruptcy.

But that's not the whole story. Most people are so deeply in debt that their credit is already damaged when they go bankrupt. And once they file for bankruptcy, their score usually goes up, not down. If the debts are erased, what is called in bankruptcy courts as "discharge," the score goes up even more.

How soon and how much can credit scores go up?

Using data from the Equifax credit bureau, researchers at the Federal Reserve Bank of Philadelphia found that taxpayer credit scores at Equifax had plunged in the 18 months before filing for bankruptcy and were rising steadily afterward.

Among the findings:

  • The average score of a person who filed for Chapter 7 in 2010 was 538.2 on the Equifax range of 280 to 850. (Scores in the low 600s and less are generally considered negative). By the time the filers' cases were closed, their average score was 620.3.

  • Chapter 13, the other type of bankruptcy, requires a three to five-year payment plan, which most people do not complete. According to an analysis of Department of Justice figures from the American Bankruptcy Institute, half of the 13 chapters filed between 2007 and 2013 were dismissed, and 12% were converted to Chapter 7 or other types of bankruptcy.), researchers at the Philadelphia Fed found.

A recent study from FICO, the company that created the leading credit score, found much smaller gains. The average credit score of people who filed for bankruptcy between October 2009 and October 2010 fell from 550 before filing to 560 afterward. According to the findings, most FICO scores are on a scale of 300 to 850.

After two years, 28% of those responsible for bankruptcy had a score of 620 or higher. After four years, 48% scored 620 or more, and only 1% scored 700 or more.

However, the FICO study did not distinguish between Chapter 7 and Chapter 13 or between those who were released and those who were not. Those with un-discharged debt could be skewing the results. In other words, people with complete bankruptcy could have seen higher earnings than those reflected in the median figures.

Saving your credit score is just one reason.

Of course, your credit score isn't the only factor to consider. Some other things to consider include:

End Collection Hell: A study found that when people were behind in their debts (with at least one account 120-day overdue, for example), their financial problems tended to get worse. Collection balances and the percentage of people with court judgment grew.

By contrast, bankruptcy applicants benefit from its "automatic stay," which disrupts almost all collection efforts, including lawsuits and forfeitures. If the underlying debt is canceled, the garnishment and lawsuits end.

Debt Relief: Chapter 7 bankruptcy eliminates many types of debt, including:

  • Civil judgments (except fraud).

  • Credit card debt.

  • Medical fees.

  • Overdue utilities.

  • Past due rent

  • Personal loans.

  • Some old tax debts.

  • Trade debts.

Some debts, including family allowances and recent tax debts, cannot be canceled in the event of bankruptcy. Student loan debt can be, but it's very rare. But if the most problematic debt can't be canceled, writing off other debt can give you the room you need to pay others.

Better access to credit: It can be difficult to get credit immediately after bankruptcy. But a study shows that people who file for bankruptcy are more likely to get new lines of credit in 18 months than people who went over 120 days or more at the same time but didn't apply.

However, your post-bankruptcy credit limits are likely to be low, and access to credit, as well as your credit score, will not be fully recovered until a Chapter 7 bankruptcy drops off your credit reports credit after ten years.

When to consider bankruptcy 

Many of us feel that we have a moral obligation to pay what we owe if we can. But usually, the opportunity is long gone by the time people begin to consider bankruptcy. They can continue to try to eliminate debt they may never be able to pay off, extending the damage to their credit score and diverting money they could use to maintain their retirement. 

If you can pay the bills, of course, you should. If you are faced with it, check your debt cancellation options. But bankruptcy may be right for you if your consumer debt equals more than half of your income or if it would take you five years or more to pay off the respective debt—austerity measures.

Here's what you need to know:

  • Don't Wait Too Long: There is a misunderstanding that people go bankrupt instantly or when they have other options. In reality, the reality is very different for some people. Some drain assets, such as retirement accounts, which could have been protected from creditors in bankruptcy. 

  • Lawyers generally want to be paid upfront: some free services and legal assistance are available, but they are often overwhelmed with demand. If you are truly strapped, speak to your local bankruptcy court to find out what resources are available. The local bar can recommend lawyers who are prepared to accept certain pro bono cases. Otherwise, you will need to raise funds to cover the cost of bankruptcy.

  • Raise money wisely: cut back on unnecessary spending if you still have it. Sell things if you have something to sell. If you keep paying off your credit cards and other consumer debt, you can stop and redirect your money to pay for a lawyer. You can also borrow from friends and family. However, do not open new credit accounts to borrow money as it could be considered fraud. Getting a second job can be problematic if your income grows above the average for your field, as it complicates the process. 

  • You Need a Bankruptcy Lawyer: It is very easy to make a mistake in complicated documents, and one mistake can get your case dismissed. If this happens, you will be left with no relief but still, lose your credit score when you file for bankruptcy.



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