SHOULD I FILE FOR BANKRUPTCY?

The bill collectors are calling.  You hate the poor soul who delivers your mail.  You stopped using your credit cards in public to avoid that embarrassing look the teller gives you when the card is declined.  Your paycheck doesn’t look like it will ever stretch to meet your debt and you don’t know what to do… so what about that bankruptcy thing?

There are two main types of bankruptcy for the average person with a lot of consumer debt:  Chapter 7 and Chapter 13.

Chapter 7 is often preferred because it comes the closest to wiping the slate clean.  Your debt.  Gone.  (Of course there are exceptions, Ask Roxy readers know that there are always exceptions in law— that is what makes it fun!).  Chapter 13 has this ugly term associated with it called “repayment plan” so let’s dig into the details of Chapter 7 first. 



Chapter 7 is only for the poor, or at least the technically poor.  If you have an income you might fail the “means test” to get into Chapter 7 and be shoved over to Chapter 13. The means test is accomplished by deducting specific monthly expenses from your “average monthly income” (your average income over the six calendar months before you file for bankruptcy) to arrive at your monthly "disposable income." The higher your disposable income, the more likely you won’t be allowed to use Chapter 7 bankruptcy because you are going to be compared with the median income for a household of your size in your state.  If you have less income than the median you pass into Chapter 7 if you don’t, you don’t.  For more on the means test check out this free calculator. 

There are more tricks and tips about qualifying for Chapter 7, but for those I will direct you to this great NOLO site and this About.com site because they are not afraid of digging into the truly boring and I’d like to get to the real point:  how soon can you start spending money again?!  I know, I know, places to go, things to buy, you want to get over this debt thingie and move on.

Here is the problem: You see, the crappy thing about Chapter 7 bankruptcy is that is screws up your credit rating.    Do you like having a car or a place to live?  Credit scores, as I’m sure you are already beginning to understand if you are reading this post, are important for financing a car, renting an apartment, qualifying for a home mortgage and even getting a job.  According to reports 60% of employers check credit scores to get a whiff of your reliability.  (Good news for my California readers though: employers ability to check credit scores is limited by law.)

So, before you throw your wallet at a bankruptcy attorney, you need to seriously consider the alternatives to Chapter 7.

DEBT SETTLEMENT:  

You may be familiar with debt settlement if you’ve ever had a friend that borrowed ten bucks but only paid you back five.  If you decided that bugging them for the last five was more bother than it was worth and you said something to your looser friend like “don’t worry about it” then you have already completed a debt settlement.  In technical terms, debt settlement is an agreement between the debtor (your good buddy) and the creditor (you) that allows the debtor to pay a part of the debt in exchange for the creditor canceling the balance.   When you decided whether or not to nag your friend you did an analysis of the emotional cost vs. the likelihood of payment.  This is probably what you thought:

“Nagging will piss him off and he’ll never pay me anyway so I might as well forget the other half of the money and just not loan anything to him ever again.”

So you “forgave” the rest of the debt.  This is very similar to the analysis that creditors do.  They aren’t worried about the emotional cost of pissing you off, of course, but they are concerned with the financial cost of paying employees or contractors to bother you and/or paying lawyers to sue you.  They have to compare that cost with the value of the debt to a debt purchaser (which will often only pay pennies on the dollar to assume the loan and then hound you).  When people do asset protection with their estate planning lawyer they are essentially trying to make it more expensive than it is worth for creditors to hunt down the money— so the creditor will settle for less than the original debt and forgive the rest.

There is a lot of art to debt settlement negotiation and so you can have the latest on these tactics I have done the heavy lifting of a five second Google search to find a website dedicated to the topic (I like the site, but no comment on their book, I haven’t read it).  Oh and just like you promised yourself to never lend money to your friend again, the creditor has already dinged your credit rating when you didn’t pay in the first place so debt settlement doesn’t completely get you out of that hole.  It isn’t as bad as a Chapter 7 bankruptcy on your score though.   Past due accounts usually only stay on your score for seven years, but a Chapter 7 bankruptcy may be on the credit rating for ten years.  Also, job applications, insurance applications, and mortgage applications might have a question about prior bankruptcy but usually won’t ask about debt settlements.

One last thing about debt settlement: creditors often issue 1099-C for the amount of debt canceled, which the lovely IRS likes to think of as income.  You may want to consult your tax advisor before a final agreement on a debt settlement.  If any of you out there are just tickled that the IRS considers forgiven debt,  even when it was forgiven to a poor person who had no hope of paying the original debt, as ordinary taxable income while some wealthy CEO’s fancy benefits package is not ordinary taxable income—I invite you to pick up your Occupy sign and meet me at the nearest corner.  

HARDSHIP PAYMENT PLANS:

If you have debt because you went through a hard time but you now have a regular income, you might find that you could pay your debt off if only the payments and interest rates were lower.  The slippery slope of debt is that the worse your track record the higher your interest rate.  Many people with debt problems are under the thumb of much higher than average interest rates.  It seems unfair unless you think back to that friend who only paid you $5 on the $10 you loaned him.  Maybe you’d give him another chance if he promised to pay you back $20 in exchange for loaning him another $10.

Enter the Credit Counseling Agency.  A credit counseling agency agrees to pay your debt for you in exchange for a low monthly fee with (usually) a lower interest rate.  Many credit counseling agencies are subsidized by the credit card industry.

Attorneys offer an alternative by negotiating directly with the creditors for lower interest rates and then the consumer continues to pay the creditor directly instead of paying a third party credit counseling service.  The main advantage of hiring an attorney over using a credit counseling agency is that with an attorney you can decide which of your creditors to negotiate with while a credit counseling agency usually wants to take over all of your consumer debt.  If you only have trouble paying the creditors with high monthly minimum payments — why not leave those other accounts alone?

THIS LEAVES CHAPTER 13 BANKRUPTCIES

I know I made fun of it earlier because of the repayment aspect, but frankly, it might be a better long term option for you than screwing your credit score with the Chapter 7 bankruptcy for ten years (Chapter 13 only shows for seven years).  Under Chapter 13 you would repay your debt according to a 3 or 5 year repayment plan.

Aside from those people who fail the means test, some people actually choose Chapter 13 because they want to protect their assets.  Let’s say you have a house, well in a Chapter 7 bankruptcy there are limits to the amount of assets you can keep.  I discuss the California homestead exemption limits in my post, “Do I really need estate planning if I’m happy to leave everything to my spouse and children?”  If the amount of equity in your home exceeds the amount of home equity protected in Chapter 7, Chapter 13 might be a better choice for you.  

Here is another example where you might want to choose Chapter 13 over Chapter 7: let’s say you are a few months behind on your mortgage.  Under a Chapter 13 repayment plan you may be able to pay that amount due over a number of years.  Chapter 7 does not provide for repayment plans unless the creditor agrees, so even if the debt is wiped out by the Chapter 7 bankruptcy Judge the lender can foreclose on the home unless it agrees to a loan modification or payment plan.  If your lender isn’t willing to agree to a loan modification, Chapter 13 might be the option for you.

Finally, those of you who have a second mortgage on your home might be able to “strip off” that mortgage through a Chapter 13 bankruptcy if the value of the home is less than what you owe on the first mortgage.  If the mortgage is “stripped off” than it is considered consumer debt, instead of secured debt, and you may be able to repay less than the full amount under a Chapter 13 repayment plan.

Chapter 13 isn’t open to everyone though.  There are rules around qualifying.  Finally, people with extremely high mortgage debt may also be interested in Chapter 11 bankruptcies, but they are more expensive and stay on your credit score for the full ten years.

SCAMS

Finally, for those of you who have been reading my posts on scams, there are many people eager to take advantage of someone in financial distress.  Keep an eye out for anyone who:

• Asks you to pay a fee before receiving any services
• Promises to magically repair your credit
• Tells you to make your debt payments to their company rather than your creditors, without your creditors’ explicit consent
• Promises to wipe out your debt without you having to declare bankruptcy or pay a fee
• Says you need professional help to contact creditors
• Tells you to stop communicating with your creditors
• Tells you you’re “eligible for a government program” to help relieve your debt – only the government agency in question can determine your eligibility

Good luck out there.