When Is Personal Bankruptcy the Best Option?

Audrey M. Jones
Frustrated Man

In a personal bankruptcy an individual receives permission from a U.S. Federal Bankruptcy Court to eliminate all or repay only some of their debts. Each of the two types of personal bankruptcy has separate eligibility requirements, impacts, and results.

Chapter 7 Bankruptcy vs. Chapter 13 Bankruptcy

There are two main types of personal bankruptcy: Chapter 7 and Chapter 13.

Chapter 7

In a Chapter 7 bankruptcy, some or all of an individual's property is sold to pay back a portion of their debt. A bankruptcy trustee appointed by the court handles these sales. However, the individual is allowed to retain any property identified as "exempt" from bankruptcy proceedings under state and federal law.

Chapter 7 does not erase all debts; debts such as alimony, child support, and tax obligations are not eliminated through Chapter 7. To pursue Chapter 7, an individual may not have income sufficient to engage in a repayment plan.

Chapter 13

In a Chapter 13 bankruptcy, the individual filing for bankruptcy keeps their property, but must make repayments for 3-5 years to repay a portion of their debt. It is up to the individual to propose the amount of repayment when he or she files a bankruptcy petition. An individual must have an income to pursue a Chapter 13 bankruptcy.

Bankruptcy Means Test

Bankruptcy isn't available to everyone. In fact, the court has established rules that limit who may declare bankruptcy.

Chapter 7 Means Test

Individuals wanting to declare Chapter 7 bankruptcy have two options:

  1. Demonstrate that they earn less than the median income for a household of their size in their state. Having a lower-than-median income automatically qualifies the individual for declaring Chapter 7 bankruptcy.
  2. Demonstrate that their disposable monthly income is insufficient to repay their debts. This option applies to individuals who earn more than the state's median income for a household of their size. To determine the amount of disposable monthly income, the individual must subtract the amount of their monthly expenses from their monthly income.

Eligibility to file for Chapter 7 bankruptcy can be determined by using an online calculator. This calculator determines whether an individual meets criteria 1 or 2 in their state.

Chapter 13 Means Test

A three-part test exists for determining eligibility to declare Chapter 13:

  1. First, an individual must prove that they have enough disposable income to satisfy any established repayment amount. This requires showing that the individual's income is large enough to make repayments after deducting the amount of payments required for secured debts and allowed expenses.
  2. Next, the individual must not have debts that exceed the maximum. Maximums are approximately $1.1 million in secured and $383,000 in unsecured debt.
  3. Finally, the individual must be current on all federal and state tax filings. Courts require proof of these filings, but may be willing to delay proceeding on a bankruptcy petition until all required tax returns are submitted.

Other Considerations for Declaring Bankruptcy

If you are deciding whether to declare bankruptcy, you might also consider:

  • Whether you are "judgment proof": This refers to creditors being unable to take your property and income even if you don't file for Chapter 7 bankruptcy. This commonly applies to individuals with no income or assets and no plans to have income or assets in the future. In this situation, you would lose nothing by not declaring bankruptcy and not pay any money to declare bankruptcy. As such, filing for bankruptcy might not be the best option.
  • Whether you can handle the harassment of not filing bankruptcy: Both Chapter 7 and Chapter 13 bankruptcy protect an individual from being called or otherwise contacted by a creditor. Not claiming bankruptcy means that creditors may still call, mail, or otherwise contact a debtor to collect the debt owed. Consider whether you can handle that contact, which may occur on a regular basis.
  • Whether you will lose the assets you need or want the most: Since the type of bankruptcy you can file determines what assets you can keep, you might consider what property you will lose if you declare bankruptcy. This requires determining what property is exempt from bankruptcy proceedings as identified by the laws of each state and federal bankruptcy laws. LegalConsumer.com has put together a helpful list of property commonly exempt in each state, but these rules can also be found on state court and bar association websites.
  • Whether you can handle the effect on your credit: Declaring bankruptcy affects your credit. Prior to declaring bankruptcy, seriously consider whether you understand and are willing to accept how bankruptcy will negatively affect your credit, especially in the long term. Rebuilding credit after a bankruptcy requires time and effort.
  • Whether you can handle repaying any debts not excused: Bankruptcy doesn't automatically allow you to avoid paying every debt. In fact, you may still have some debts that you are required to continue paying. Determine which debts are not erased by declaring bankruptcy and whether those debts make it worthwhile to declare bankruptcy prior to filing for either Chapter 7 or 13.
  • Whether you are currently facing foreclosure or are engaged in a lawsuit: Bankruptcy places an automatic stay on all creditor actions to repossess property due to nonpayment of a debt or collect on a debt. If you are involved in a lawsuit regarding collecting a debt or are facing foreclosure or repossession, filing for bankruptcy may enable you to avoid these losses for some time or indefinitely.

When Bankruptcy Makes Sense

Each individual's situation is different and there is no single circumstance in which filing for bankruptcy is appropriate. If an option other than bankruptcy - such as negotiating debt - is suitable to the situation, declaring bankruptcy may not be the best option. However, when an individual cannot pay their debts, is being hounded by creditors, is facing lawsuits or other legal actions to repay their debts, can handle the consequences to their creditworthiness, seeking bankruptcy may be the best option.

Options Other than Bankruptcy

Bankruptcy is not the only option for individuals facing an inability to repay large amounts of debt. Other options include:

  • Negotiating with creditors: Most creditors would be satisfied to receive any sort of repayment of a debt rather than lose any chance of recovering funds after a bankruptcy. Many times, you can negotiate with creditors to reduce the amount you will pay simply by explaining the situation and asking what they can do. Note, however, that this may impact your creditworthiness.
  • Seeking assistance from a credit counseling agency: A credit counseling agency negotiates with creditors on your behalf. Many times, these agencies are able to significantly reduce the amount you pay or combine all your negotiated and reduced debt repayments into a single payment. This option also likely affects your creditworthiness.
  • Doing nothing: This option is suitable for individuals who are judgment-proof. However, it may result in them being contacted on a regular basis by creditors.

Are You Considering Bankruptcy?

Filing for bankruptcy in the court and being declared bankrupt has serious consequences on creditworthiness and future finances. Prior to seeking bankruptcy, determine whether any other options can assist you in with your finances. Consider speaking with a legal professional to help you decide if bankruptcy is best for your situation.

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When Is Personal Bankruptcy the Best Option?