Q&A: When bankruptcy doesn't make sense

Your debt may seem insurmountable, but may not qualify for bankruptcy

Opening Credits columnist Eric Sandberg
Erica Sandberg is a prominent personal finance authority and author of "Expecting Money: The Essential Financial Plan for New and Growing Families." She writes "Opening Credits," a weekly reader Q&A column about issues for people who are new to credit, for CreditCards.com.

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Question Dear Opening Credits,
I have close to $5,000 in debt on credit cards and two unpaid utility bills. If I file Chapter 7, which takes four to six months to complete, how long will it take before I can get an apartment or credit card? Also, would I have to go to court for this? What paperwork would I need to provide? I have five unpaid credit cards. – Salman

Answer

Dear Salman,
I understand the desire to walk away from your debt, but bankruptcy is not a universal cure. With the amount you owe and the types of bills you have, I get the sense bankruptcy is not the right solution for you.

In short, if you can pay your bills, you should. While $5,000 (plus those utility bills, which are unlikely to be too high) may feel like an insurmountable burden, there might be better ways to deal with the problem.

First, know whether you actually can use Chapter 7 bankruptcy protection. To qualify, you have to pass a “means test.” If the amount you earn is less than the median income of a similar household in your state, you are automatically eligible.

However, if your income is higher, you’ll have to prove you can’t afford to repay your debts by filling out the Summary of Your Assets and Liabilities and Certain Statistical Information form. All of your earnings, property, expenses and liabilities will be scrutinized.

If, after covering essential expenses, you have virtually no funds remaining to pay your debts, discharging them with a Chapter 7 is possible. Use this means test calculator to see where you stand.

Even if you do pass the means test, not all debts are dischargeable. For example, if you used your credit cards to purchase luxury items 60 to 90 days before filing, you’ll be stuck with the total of those charges. And if you own property that is not exempt from being claimed by your creditors, you could end up losing it.

Each state has its own exemption list, but in general you get to keep your home, car, furniture and a limited amount of personal property. Boats, expensive jewelry, secondary cars or anything else that’s valuable and extraneous are at risk of being sold, with the proceeds routed to pay your creditors.

Then again, if you have such luxurious items, you could do the same by selling them and paying off your debts. It would offset the need for a bankruptcy and improve your credit rating. Satisfied obligations are always perceived more favorably than those that were discharged.

Regarding paperwork and the process, it begins with taking the required debtor education course. In it, you’ll learn about budgeting, credit and other personal finance topics. After that, you must take and pass a test indicating that you’re knowledgeable about the subjects. You can find course providers on the U.S. Trustee’s website.

Most of the bankruptcy education providers are credit counseling agencies. These organizations are set up to help people manage their money and credit.

A debt repayment plan through a credit counseling agency may be a viable alternative to bankruptcy, too. If you have enough disposable income to send a monthly payment to your credit card issuers, you can pay through the agency and get lowered interest rates. The plan is arranged so you’re out of debt in three to five years.

Credit counseling is free, and you’ll learn if bankruptcy makes sense for you. You can find an accredited credit counseling agency at the National Foundation for Credit Counseling or the Financial Counseling Association of America.

If you do go forward with the Chapter 7 bankruptcy, you can represent yourself, though most people retain a lawyer. After filing the paperwork, an automatic stay will be in effect, which will stop creditors from contacting you until you appear in court. (Yes, you have to go).

Presuming the bankruptcy is approved, you will receive the formal discharge of debts. From start to finish, it takes between four and six months.

As for your credit rating, the bankruptcy notation will be remain on your reports for 10 years from the filing date. The bankruptcy notation will have a severe negative effect on your credit scores for a couple of years. During that time, any credit products you apply for will have high interest rates and poor terms.

Employers are not permitted to discriminate against a person who has filed for bankruptcy, but that doesn’t mean some don’t. Landlords can, though, and in a tight housing market it could cause trouble.

For all these reasons, repaying your debts is best. If you can reduce spending or increase income to make it happen, do it! 

See related: Your map through Chapter 7 and Chapter 13 bankruptcy, 7 times when bankruptcy can make sense

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Updated: 11-24-2017