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US bankruptcy law gives people overwhelmed by debt a chance to get back on their feet and start fresh. While bankruptcy can provide financial relief, the potential negative impact on your credit score and overall finances should not be overlooked. Understanding the ins and outs of filing for bankruptcy is key to deciding if it’s right for you.
Here’s what you need to know about the consequences of filing for bankruptcy, along with some alternatives to consider.
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What are the consequences of filing for bankruptcy?
If you’re thinking about filing for bankruptcy, consider these consequences.
Lowered credit rating
Your credit score measures your ability to pay off debt, so filing for bankruptcy is likely to take a hit on your credit score. A bankruptcy stays on your credit report for up to 10 years and continues to affect your score at that time. However, it is possible to rebuild your credit after bankruptcy.
Reduced access to credit
Bankruptcy reduces your ability to obtain new credit. If you can qualify for loans at all, they will likely have high interest rates and reduced credit limits. Mortgage eligibility is particularly limited after bankruptcy. Depending on the type of bankruptcy you file for, you may have to wait up to four years before you can apply for a home loan. That waiting time is reduced to two to three years for federally-backed mortgage loans, and individuals who file for Chapter 13 bankruptcy (rather than Chapter 7) may only have to wait a year or two.
Loss of tax refund
While you can get tax refunds during bankruptcy, your refund can be used to pay off federal tax debts. One of the consequences of Chapter 7 bankruptcy is that your tax returns may be turned over to your bankruptcy trustee to cover debts.
Possible Loss of Assets
Filing for bankruptcy can delay home foreclosures and car repossessions, but ultimately some wealth loss is possible. In Chapter 7 bankruptcy, non-exempt assets are liquidated to compensate your creditors. And while Chapter 13 bankruptcy lets you keep your assets while you make payments on an adjusted debt plan, those assets may be at risk if you default on your repayments.
Some debts remain
Some debts cannot be paid off through bankruptcy. In general, debts incurred as a result of improper or illegal behavior on the part of the debtor cannot be settled. This contains:
- Debts not reported when filing for bankruptcy
- child support and child support payments
- Certain Tax Claims and Unpaid Federal Income Tax
- Debt for intentional and malicious damage to property or personal injury
- Amounts owed to certain tax-advantaged retirement plans
- Certain condominium or co-op fees
Student loan debt is also notoriously difficult to pay off — although a recently introduced law, the Student Borrower Bankruptcy Relief Act of 2022, could change that if passed.
The bankruptcy is public knowledge, so future employers or clients, family and neighbors can access this information. In addition, anyone responsible for your debt is affected by the filing. If you have a co-signer on one of your debts, creditors may still be able to sue them for the balance even if the debt is settled in your bankruptcy. If you co-own a business, your partner may need to buy you out to keep the business going.
Things to do before filing for bankruptcy
Completing these tasks before filing for bankruptcy can help minimize the consequences mentioned above.
Submit your taxes
If you file for Chapter 13 bankruptcy, the IRS requires you to first file all required tax returns for all tax periods ending within the last four years. You must also file and pay taxes applicable during the bankruptcy proceedings or apply for an extension. Your case may be dismissed if you fail to file your tax returns or pay taxes during the bankruptcy proceedings.
Avoid new debt
Make sure you don’t incur any new debt in the 70 to 90 days before you apply. Deliberately accumulating debt that you don’t want to pay off is considered fraud. Cash advances over $750 or luxury goods over $500 purchased within this time frame are likely to be considered non-recoverable debt.
Visit credit counseling
You must take a credit counseling course conducted by an approved credit counseling agency within 180 days of filing for bankruptcy. The credit advisor can explain the possible consequences of bankruptcy and help you choose your options.
Bankruptcy is one of many possibilities. Here are a few alternatives.
Sell your assets
Your non-exempt assets may be liquidated during bankruptcy proceedings, so consider what could be sold before filing for bankruptcy. You’re likely to make more money selling the assets yourself rather than letting them go into a bankruptcy auction, and that extra money may be enough to improve your financial situation. Be sure to keep all records of the sales and calculate a fair market price as selling assets well below their value can set red flags if you need to file for bankruptcy.
Strive for extra income
If you are able to increase your income, you may be able to avoid bankruptcy. Consider taking a part-time job and becoming a gig worker in your free time. You can also try to negotiate a raise with your current employer. Earning a few hundred dollars more each month can save you thousands of dollars in interest over the long term.
Debt Consolidation and Refinancing
If you have good credit and need to reduce your monthly debt payments, consider a debt consolidation loan. This option works well if you can qualify for a loan with a lower interest rate or monthly payments than your current debt.
While debt consolidation loans are typically unsecured loans, secured loans are sometimes touted as an option for people with bad credit. It is generally advisable to avoid taking out a secured loan to cover your unsecured debts as this will put your assets at risk. If you have high-interest debt, such as For example, if you have a “buy here, pay here” car loan from a dealership, it may be beneficial to refinance your debt through your bank at a lower interest rate.
Contact your creditors
Your creditors are eager to recover as much of your owed balance as possible, so they may be willing to work with you to negotiate alternative terms or repayment schedules. Contact the lender or collection agency and explain your circumstances. Provide a realistic estimate of what you can pay and when you can make those payments. Your creditors may be willing to slash fees or reduce your interest rate or monthly payment.
You can negotiate your debt yourself or work with a credit counselor, attorney, or debt adjustment firm. Ensure all agreements are in writing and keep detailed records of communications and payments.
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