Saturday, November 13, 2010

How Does Bankruptcy Work?

Seal of the United States bankruptcy court. Ch...Image via Wikipedia

Bankruptcy was created to protect the financial health of the jobless and the infirm by eliminating high levels of debt. There are two ways to file for bankruptcy, each with its own rules. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Bankruptcy Reform Act), made many changes in bankruptcy law.

Under a Chapter 7 bankruptcy filing, many debts are eliminated, but the filer must liquidate personal assets to pay down some of the debt. Personal property is sold by a bankruptcy trustee, who then uses the proceeds to pay creditors. Some assets are exempt if they are considered necessary to support the filer and any dependents, but state and federal laws vary widely. In general, a percentage of home equity and disability benefits are exempt, and Chapter 7 filers may be allowed to keep any money or property they obtain after filing. Chapter 7 bankruptcy can be filed once every eight years.

A Chapter 13 filing does not erase debt. Rather, it requires the filer to set up a repayment plan, typically over a three- to five-year period, in exchange for keeping personal assets. The Bankruptcy Reform Act of 2005 states that anyone with income above the state median will have to file for Chapter 13 and pay back at least a portion of their debts. In general, homes will only be protected if owned for at least 40 months. Chapter 13 bankruptcy can only be filed once every two years.

Certain debts cannot be erased under any bankruptcy filing, including alimony, child support, property settlements, criminal judgements and fines, student loans, and most taxes. In addition, a bankruptcy filing will not allow you to keep property that secures a loan, such as an automobile or home, unless you repay the loan.

Who Should File?

In general, filing for bankruptcy should be avoided. Filing, however, may help to begin a financial recovery if:
You cannot meet debt obligations on current income.
Attempts to negotiate payments with creditors have failed.
Your ratio of debt to annual income is 40% or more.
Previous attempts to reduce debt have failed, particularly with the help of a credit counselor or debt reduction plan.
You have charge-offs on your credit history. Charge-offs appear when you have debts that are more than 250 days past due that are written off by your creditors for accounting purposes. A series of charge-offs and bankruptcy are both black marks on your credit report, but a bankruptcy filing demonstrates that you have at least dealt with the debt.

Source: National Institute for Consumer Education

Alternatives to Bankruptcy

Bankruptcy, and the resulting credit difficulties, is not the only way to manage excessive debt. You can try to negotiate a payment plan with a creditor and perhaps reduce your debt. Credit card companies faced with the rising number of bankruptcy filings may prefer to get some of what's owed them rather than have the entire debt erased.

You can conduct these negotiations on your own, with the help of an attorney, or through a professional credit counselor, who specializes in credit negotiations and will charge less than an attorney for the service. Payments for the negotiated debts can be deducted directly from your paycheck by the counseling service, which then distributes the money to creditors. Credit counselors will also work with you to rebuild your credit and improve your long-term financial situation.

Though the stigma surrounding bankruptcy has lifted, it should still be seen as a last resort after all other methods of settling debt have been exhausted. The thought of your debt being erased may be attractive, but the financial hardships bankruptcy can create far outweigh any benefits.

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