When bankruptcy is the best option


Bankruptcy is not the end of the world. It may even be good for you.

Bankruptcy stops collection calls, lawsuits and wage garnishments. He clears the debt. And despite what you’ve heard, bankruptcy can improve your credit scores.

Credit bureaus and scoring experts often say that bankruptcy is the worst thing you can do to your scores. Foreclosures, repossessions, write-offs, collections – nothing else can bring your scores down as fast and far as bankruptcy.

But that’s not the whole story. Most people struggle with debt for so long that their credit is already bad by the time they file for bankruptcy. And once they do, their scores usually increase, not decrease. If the debt is written off – what bankruptcy courts call a “discharge” – the scores rise even more.

“In a year, your situation is much better,” says Jaromir Nosal, assistant professor of economics at Boston College, co-author of a study for the Federal Reserve Bank of New York on the effects of bankruptcy. “It’s a pretty quick recovery rate.”

It’s time to crush the debt

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How much and how quickly can credit scores increase?

  • The average credit score of a person who has filed Chapter 7, the most common type of bankruptcy, in 2010 was 538.2 of Equifax’s 280 to 850 range. (Scores below 600 and below are generally considered poor.) By the time the filers’ records were released, 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 do not complete. (Half of the Chapter 13 files filed between 2007 and 2013 were rejected, and an additional 12% were converted to Chapter 7 or other types of bankruptcy, according to an American Bankruptcy Institute analysis of Department of Justice figures. Those who did and got a release, however, saw their scores drop from 535.2 to 610.8, according to researchers at the Philadelphia Fed.

A recent study from FICO, the company that created the best credit score, found much smaller gains. The median credit scores of people who filed for bankruptcy between October 2009 and October 2010 dropped from 550 before they filed to 560 afterwards, says Ethan Dornhelm, senior director of the Scores and Analysis group at FICO. (Most FICO scores are on a scale of 300 to 850.)

After two years, 28% of bankrupt filers had scores of 620 and above. After four years, 48% had scores of 620 or more, and only 1% had scores of 700 or more.

But the FICO study did not distinguish between Chapter 7 and Chapter 13, or between people who got discharged and those who didn’t. Those with unpaid debt could skew the results. In other words, people who went bankrupt could have seen larger gains than what the median numbers reflect, Dornhelm says.

Saving your credit score is just one reason

Credit scores aren’t the only factor to consider, of course. Some of the others:

The end of the hell of the collection: Nosal’s study found that once people fell far behind on their debt – with at least one account 120 days past due, for example – their financial problems tended to get worse. Collections balances and the percentage of people who have been judged have increased.

In contrast, people who file for bankruptcy benefit from its “automatic stay,” which interrupts almost all collection efforts, including lawsuits and wage garnishment. If the underlying debt is written off, the lawsuits and garnishment end.

Freedom from certain debts: Chapter 7 bankruptcy eliminates many types of debt, including:

  • Civil judgments (except fraud).

Some debts, including child support and recent tax debt, cannot be written off in bankruptcy. Student loans can be, but it’s very rare. But if your worst debt can’t be paid off, writing off other debts might give you the leeway you need to pay off what’s left.

Better access to credit: It can be difficult to get credit right after bankruptcy. But Nosal’s study shows that people who have filed for bankruptcy are more likely to get new lines of credit within 18 months than people who are 120 days or more late at the same time but have not. filed declaration.

Your credit limits after bankruptcy will likely be low, however, and your access to credit – like your credit scores – won’t fully recover until a Chapter 7 bankruptcy wipes out your credit reports after 10 years.

It’s been a long time in the penalty box. But let’s get rid of 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 that we have a moral obligation to pay what we owe – if we can. But generally this ship has sailed by the time people realize they have to consider bankruptcy. They can continue to try to reduce debts that they might never be able to repay, thus prolonging the damage to their credit rating and diverting money that they could use to support themselves. retirement. Or they may recognize an impossible situation, face it and move on.

If you can pay your bills, obviously you should. If you are having difficulty, see your options for debt relief. But bankruptcy may be the best option if your consumer debt – the types listed above that can be wiped out – equals more than half of your income, or if it would take you five years or more to pay off that debt, even with extreme austerity measures.

Here’s what you need to know:

You need a bankruptcy lawyer: It’s easy to get confused with complicated paperwork, and one mistake could result in your case being rejected. If this happens, you end up with no relief – but you still have weakened credit scores from filing for bankruptcy.

Lawyers generally want to be paid up front: Legal aid and pro bono services are available, but they are often overwhelmed with demand. If you are really strapped for it, call your local bankruptcy court to find out what resources are available. Your local bar may be able to direct you to attorneys willing to take on certain pro bono cases. Otherwise, you will have to collect the money.

Collect money the smart way: Cut back on unnecessary expenses, if you still have them. Sell ​​things, if you have something to sell. If you are still paying off your credit cards and other consumer debt, you can stop and redirect the money to pay a lawyer. Another option is to borrow from friends and family. Do not open new credit accounts to borrow money, as this could be considered fraud. Working a second job can be problematic if you increase your income above the median for your area, as it complicates your reporting. Discuss your options with a lawyer; many offer a free or low cost initial consultation.

Don’t wait too long: There is a misconception that people file for bankruptcy in the blink of an eye or when they still have other options. The reality for most is quite different. Some drain assets, like their retirement accounts, that could have been protected from creditors in bankruptcy. People throw money away after a bad time until they run out of money to ask for help.

That is why we advise debtors above 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. “This is when people really suffer.”

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