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The US bankruptcy code gives people overwhelmed with debt the opportunity to get back on their feet and start fresh. Although bankruptcy can offer financial relief, the potential negative impact on your credit and overall finances should not be overlooked. Understand the advantages and disadvantages of bankruptcy is the key to deciding if it’s right for you.
Here’s what you need to know about the consequences of applying for bankruptcy with some alternatives to consider.
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What are the consequences of filing for bankruptcy?
If you are considering declaring bankruptcy, keep these consequences in mind.
Reduced credit score
Your credit score gauges your ability to repay your debts, so filing for bankruptcy will likely take a toll on your credit. A bankruptcy stays on your credit report for up to 10 years and will continue to impact your score during that time. That said, it is possible to rebuild your credit after bankruptcy.
Reduced access to credit
Bankruptcy decreases your ability to obtain new credit. If you qualify for loans, they will likely have high interest rates and low credit limits. Mortgage qualification is particularly limited following bankruptcy. Depends on type of bankruptcy you file, you may have to wait up to four years before applying for a home loan. This waiting period is reduced to two or three years for government-backed mortgages, and people applying Chapter 13 bankruptcy (rather than Chapter 7) may only have to wait one to two years.
Loss of tax refund
Although you can receive tax refunds in the event of bankruptcy, your refund can be used to pay off federal tax debt. One of the consequences of Chapter 7 bankruptcy is that your tax return may be turned over to your trustee in bankruptcy to cover debts.
Potential loss of assets
Filing for bankruptcy can delay foreclosure of the house and repossession of the car, but eventually loss of property is possible. In Chapter 7 Bankruptcy, non-exempt assets are liquidated to compensate your creditors. And while Chapter 13 Bankruptcy allows you to keep your assets while making payments on an adjusted debt plan, if you fail to meet your repayments, those assets may be at risk.
Some debts persist
Some debts cannot be discharged through bankruptcy. In general, debts incurred as a result of the debtor’s abusive or illegal behavior cannot be discharged. This includes:
- Debts not declared when filing for bankruptcy
- Child support and alimony
- Certain tax debts and unpaid federal income tax
- Debts for intentional and malicious property damage or bodily injury
- Amounts owed to certain tax-advantaged pension plans
- Certain condominium or cooperative housing fees
Student loan debt is also notoriously difficult to service, although a recently introduced bill, the Student Borrower Bankruptcy Relief Act of 2022, could change that if passed.
Bankruptcy is a public record, so future employers or clients, family and neighbors can access this information. Also, anyone who shares responsibility for your debt will be affected when you file. If you have a co-signer for one of your debts, creditors may still be able to sue them for the balance, even if the debt is discharged in your bankruptcy. If you are a co-owner of a business, your partner may be required to buy you out to keep the business going.
Things to do before declaring bankruptcy
Taking care of these tasks before filing for bankruptcy can help minimize the consequences mentioned above.
File your taxes
When filing for Chapter 13 bankruptcy, the IRS requires that you first file all required tax returns for all tax periods ending within the past four years. You must also file and pay any applicable taxes during the bankruptcy process or request an extension. Your case may be rejected if you fail to file your return or pay taxes during the bankruptcy process.
Avoid new debt
Be sure to avoid incurring new debt for 70-90 days before you file. The intentional accumulation of debts that you do not intend to pay is considered fraud. Cash advances totaling more than $750 or luxury goods over $500 acquired within this time frame will likely be considered non-dischargeable debt.
Attend credit counseling
You must attend a credit counseling course administered by a licensed credit counseling agency within 180 days of filing for bankruptcy. The credit counselor can explain the consequences of bankruptcy that you may face and help you navigate your options.
Alternatives to bankruptcy
Bankruptcy is one of many options. Here are some alternatives.
Sell your assets
Your non-exempt assets may be liquidated during bankruptcy proceedings, so before filing for bankruptcy, think about what could be sold. You are likely to generate more money by selling the assets yourself instead of letting them go to a bankruptcy auction, and that extra money may be enough to improve your financial situation. Be sure to keep any sales documentation and charge a fair market rate, as selling assets well below value can set off red flags if you need to file for bankruptcy.
Look for extra income
If you have the ability to increase your income, you may be able to avoid bankruptcy. Consider getting a part-time job and becoming a gig worker in your spare time. You can also try to negotiate a raise with your current employer. Bringing in a few hundred extra dollars each month could save you thousands of dollars in interest in the long run.
Debt consolidation and refinancing
If you have good credit and need to lower your monthly payments, consider a debt consolidation loan. This option works well if you can qualify for a loan with a lower interest rate or lower monthly payments than your current debt.
Although debt consolidation loans are generally unsecured loans, secured loans are sometimes touted as an option for people with poor credit. It’s generally wise to avoid getting a secured loan to cover your unsecured debt, as it puts your assets at risk. If you have high interest rate debt, such as a “Buy Here, Pay Here” car loan from a dealership, it may be beneficial to consider refinancing your debt at a lower rate through your bank.
Communicate with your creditors
Your creditors are invested in collecting the balance owing as much as possible, so they may be willing to work with you to negotiate alternative terms or repayment plans. Contact the lender or debt collector and explain your situation. Provide a realistic estimate of what you can pay and when you can make those payments. Your creditors may be willing to waive the fee or reduce your interest rate or monthly payment.
You can negotiate your debt on your own, or you can work with a credit counselor, lawyer, or debt settlement company. Be sure to get all agreements in writing and keep detailed records of communications and payments.
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