Bankruptcy Pros and Cons: Don’t Declare Until You Read This

According to the Administrative Offices of the United States Courts, bankruptcy filings are on the rise, with 452,990 cases filed in 2023, a 16.8% increase from the previous year. But that doesn’t make filing for bankruptcy right for everyone.

If you’re drowning in debt, knowing where to turn can feel impossible. While filing for bankruptcy can give you a fresh start, I urge you to consider its pros and cons before making a decision that could affect your financial situation for another decade.

Pros and cons of bankruptcy

How does filing for bankruptcy work?

Individual bankruptcy laws have been in place for nearly 150 years. These federal laws are designed to give a second chance to individuals who've struggled financially and can't figure out how to pay off debt.

No matter the type of bankruptcy you file, here are the basic steps for filing:

1. Gather information about your assets and liabilities
2. Consult with a bankruptcy attorney to ensure your debt qualifies for bankruptcy
3. File a bankruptcy petition
4. Complete all court-ordered forms, including a financial statement
5. Complete required credit counseling or debtor education courses
6. Meet with creditors (or your attorney may do this for you)
7. Receive notice of discharge

Not all bankruptcy cases are approved. Your fate is in the hands of a bankruptcy judge who will determine if your situation warrants filing a bankruptcy, especially if you petition for a Chapter 7 bankruptcy, which discharges most debts.

Bankruptcy Chapter 7 vs. Chapter 13

When you're learning about bankruptcy basics, you may come across the three common types of personal bankruptcy filings, typically categorized by chapters under the United States bankruptcy code.

If you opt to file bankruptcy, you'll likely file for either Chapter 7 or Chapter 13 since they're the most common types of bankruptcy. If you're filing bankruptcy for your business, you may file for Chapter 11.

A Chapter 7 bankruptcy liquidates your eligible assets to pay off creditors, and any remaining eligible debt is discharged. A Chapter 13 bankruptcy reorganizes your debts and creates a more affordable repayment plan for your situation.

6 possible benefits of bankruptcy

I know society generally has a negative attitude toward bankruptcy, but sometimes, some good can come from it. However, if you receive approval to file bankruptcy, it’s important to learn the basics of budgeting to prevent it from happening again.

1. You could consolidate your debt (or have it discharged)

Keeping up with debt payments is hard when you can’t afford them. Depending on the type of bankruptcy you request, bankruptcy may offer some debt relief by consolidating your debt into manageable payments, or the judge may eliminate your responsibility for some debts.

Having a more affordable payment plan or eliminating debt gives you a fresh start and the chance to learn how to manage your money better.

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2. You may get to keep some assets

There are some personal exemptions when you file for bankruptcy, so you could keep things like your home, car, or retirement accounts in either Chapter 7 or Chapter 13 filings. Bankruptcy exemptions vary by state and the value of your assets. I always suggest speaking with a licensed attorney to understand your options.

3. You may settle for less than you owe

When you involve the courts in your financial situation, your creditors must accept the payment the judge decides. This is more likely with a Chapter 7 bankruptcy after the judge liquidates any eligible assets. However, if you file a Chapter 13 bankruptcy, you’ll have a payment plan or a settlement agreement for a lesser amount, depending on how the judge rules.

Settling for less than you owe may provide some emotional relief as it may seem easier to tackle the debt or that there’s a light at the end of the tunnel.

4. Filing bankruptcy should put a stop to debt collection attempts

When you file for bankruptcy, creditors must stop contacting you to collect a debt as a part of the automatic stay law. This begins immediately after you officially file for bankruptcy and continues throughout the legal bankruptcy process.

This means all phone calls, collection letters, and other attempts must stop. This can release a tremendous amount of pressure from you as collection calls can be draining.

Remember, though, not every amount you owe will be a debt that goes away when you declare bankruptcy, so if you have a debt that falls under the exclusions, you may still have to deal with creditors.

5. You don’t have to deal with multiple creditors

Trying to juggle multiple creditors, prioritize some debts over others, and keep up with your standard bills can feel overwhelming. When you file for bankruptcy, you have one court-appointed trustee handling the communication between you and the creditors. If you file a Chapter 13 bankruptcy, the trustee is also responsible for distributing the payments to the appropriate creditors.

6. You get a fresh start

Immediately after your bankruptcy is discharged, you can begin rebuilding your credit. While it’s not easy to bounce back after bankruptcy, with consistency and the right financial support, you can start from scratch, putting your negative credit history behind you.

8 downsides of bankruptcy

Bankruptcy has the potential to help you in a dire financial situation, but it can also have devastating consequences for your future. Bankruptcy should be a last resort after exhausting all other options. If you’re considering it, make sure you know the possible blows you’ll face.

1. Your credit will tank

If you’re months (or years) late in paying outstanding debt, your credit score may already be low in the credit score ranges. Still, a bankruptcy filing can cause additional harm to it—the more accounts listed in your bankruptcy filing, the more significant the impact on your credit score. In addition, a bankruptcy filing can stay on your credit report for seven to 10 years, depending on which chapter you file under.

2. It could be harder to borrow in the future

Having a bankruptcy mark on your credit report is like having a black cloud over your head for as long as a decade. Lenders see bankruptcy marks as a big red flag and often hesitate to work with you. It could stop you from getting a home, car, or even a credit card in the future.

Even if you are approved for a loan or credit card, the terms will likely be stricter. For example, you may only qualify for a secured credit card rather than a traditional one, or you may qualify for a loan but with much higher interest rates and fees.

3. Not all types of debt are eligible for bankruptcy

A big misconception about bankruptcy is that you’re no longer responsible for paying any current debt if you declare it. While filing for bankruptcy may help wipe out unsecured debt like medical bills, personal loans, or credit card debt, not all debt can be included in bankruptcy filings.

For example, secured debt like mortgages remain your responsibility after filing. Alimony and child support are also ineligible for discharge by bankruptcy. This means that even if you declare bankruptcy, you may still have outstanding debt. Depending on your debt, bankruptcy may not be worth it.

4. Purchasing a home after bankruptcy can be challenging

After filing for bankruptcy, you may have to wait two to four years before you can apply for a mortgage. It depends on the type of mortgage you apply for and the type of bankruptcy you file. FHA loan requirements have the shortest waiting period after a bankruptcy discharge, and conventional loans have the strictest requirements. It is still up to the individual lender if they feel comfortable lending to you.

5. It can be hard to qualify for

If you declare Chapter 7 bankruptcy, you must prove you can’t afford to repay your debt through a means test. This test ensures your income is low enough to declare bankruptcy. If it isn’t, your disposable income will be evaluated to see that after your important expenses (like housing and child support), you have nothing left over to pay for your debt. Not everyone has enough debt to file for bankruptcy.

6. It could take years to complete a Chapter 13 bankruptcy

If you successfully declare Chapter 13 bankruptcy, you could face years of paying a court-ordered repayment plan. Repayments under a Chapter 13 filing typically take anywhere from three to five years to complete.

7. Your cosigners could be on the hook

If someone cosigned a loan or credit card for you and you don’t repay the debt, they could be responsible. Not only do the missed payments affect your credit score, but they also decrease the cosigner's score. Plus, even if you receive approval to file for bankruptcy, the cosigner may still be responsible for the cosigned debt.

8. Bankruptcy isn’t free

Before filing for bankruptcy, consider how much it costs to file bankruptcy. It sounds crazy to think you have to pay to get help with your debts, but there are fees you must pay to file including filing costs of at least $300 for both chapters, and the cost of a bankruptcy attorney, which could cost several thousand dollars.

4 alternatives to filing for bankruptcy

As I said earlier, filing for bankruptcy is a last resort you should seek only after exhausting other potential routes. Several alternatives you can explore may enable you to avoid bankruptcy.

1. Consolidate your debt

Debt consolidation combines two or more debts into one. The most common debt consolidation method involves using a loan to pay off all your debts, resulting in a single loan to pay off.

A debt consolidation loan helps you manage your debt more easily and may give you a lower interest rate than what you had on your original debt. That’s why debt consolidation loans can help you with credit card debt by potentially providing you with a lower interest rate that is easier to manage.

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3. Settle your debt

Debt settlement is a process where you negotiate with a creditor or a debt collector a payment lesser than the amount you owe to settle the account. This can be a win-win outcome for you and your creditor since you eliminate your debt while your debtor gets a portion of their money.

You can attempt to settle debts you owe on a credit card or for a medical bill, as well as unsecured personal loans and private student loans. To negotiate your debt, you may either contact your debtor directly or use a debt settlement company that helps you define the terms of your debt settlement. Before choosing this route, be sure you understand the difference between debt settlement versus debt consolidation.

4. Manage your debt

Debt management is when you design a plan or use an agency to design a plan for you to pay off your debt. It may also include negotiating your total debt amount, monthly payments, or interest rates.

Using a debt management agency can help you avoid bankruptcy and find ways to pay down your debt over time. However, it requires your commitment and effort to make the plan successful.

Debt management companies may help you with credit card, medical, and personal debts. However, most companies will review your debt, income, and finances to confirm your eligibility for their plans. Before choosing this option, be sure to understand the differences between debt management versus debt settlement.

Bankruptcy FAQs

Bottom line

I urge you to consider the potential negatives of filing bankruptcy, from the cost of filing for it to the negative effects on your credit score. While a fresh start may sound like a good idea, bankruptcy doesn’t go away for a long time and can seriously impact your borrowing in the future.

Bankruptcy should be a last resort, saved for when you don’t have any other choice. Before you decide to file, explore all your other options, such as debt consolidation and budgeting changes. If you feel like you have no other options, consider consulting a law firm that offers free consultations to get legal advice before filing.

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