When bankruptcy is the best option

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

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

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

But that’s not the whole story. Most people struggle with debt for so long that their credit is already weak by the time they file for bankruptcy. And once they do, their scores usually go up, don’t go down. If the debt is written off – what the bankruptcy court calls a “discharge” – the scores rise even more.

“A year from now you’re much better off,” says Jaromir Nosal, assistant professor of economics at Boston College, who co-authored 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 debts

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By how much and how quickly credit scores can increase

  • The average credit score of a person who has filed Chapter 7, the most common type of bankruptcy, in 2010 was 538.2 on Equifax’s 280-850 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, the Philadelphia Fed researchers found.

A recent study by FICO, the company that created the main credit score, found much lower earnings. The median credit scores of people who filed for bankruptcy between October 2009 and October 2010 fell 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 a score 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 debts could skew the results. In other words, people who went bankrupt could have seen larger gains than what is reflected in the median numbers, says Dornhelm.

Saving your credit score is just one reason

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

End of the hell of the collection: Nosal’s study found that once people got seriously 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 adjudicated 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.

Release of certain debts: Chapter 7 bankruptcy wipes out many types of debt, including:

  • Civil judgments (except for fraud).

Some debts, including child support and recent tax debt, cannot be written off in bankruptcy. Student loan debt can be, but it’s very rare. But if your most troublesome debt can’t be paid off, wiping out other debt might give you the space 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 haven’t filed. of the folder.

However, your credit limits after bankruptcy are likely to be low and your access to credit, like your credit scores, will not recover fully until a Chapter 7 bankruptcy makes your credit reports disappear after 10. years.

It’s long in the penalty area. But let’s get rid of the idea that bankrupt people 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 like 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 they may never be able to pay off, prolonging the damage to their credit scores and diverting money they could use to support themselves in 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, check 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) is more than half your income, or if it would take you five years or more to pay off that same debt. with extreme austerity measures.

Here’s what you need to know:

You need a bankruptcy lawyer: It’s easy to make a mistake in complicated paperwork, and one mistake could result in your case being rejected. If this happens, you are left with no relief, but you still have credit scores due to filing for bankruptcy.

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

Collect money the smart way: Cut back on unnecessary expenses, if you still have them. Sell ​​stuff 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, such as their retirement accounts, that could have been protected from creditors in bankruptcy. People throw money after evil until they run out of money to seek 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,” says Nosal. “This is when people really suffer.

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