Pros and cons of bankruptcy

The following is for informational purposes only and not to be construed as legal advice. If you have any questions about bankruptcy, you should consult with a licensed attorney.

Are you up to your ears in debts you can’t pay? You have options for managing your financial situation. Exploring debt solutions such as bankruptcy is the first step on the path to a more stable financial future. 

If filing for bankruptcy is the right option for getting your finances stabilized, that's nothing to be ashamed of. Bankruptcy has a reputation for being an option of last resort, but it’s better to think of it as a financial decision, not a moral one. 

We’ll help you weigh the pros and cons of bankruptcy and get some perspective on whether it can help you. 

Bankruptcy explained

What is bankruptcy? It's a legal process for dealing with debt. There are two main types of bankruptcy cases individuals can file: Chapter 7 and Chapter 13 (Chapter 12 is also an option if you’re a fisherman or farmer).

Chapter 7 is often called the clean-slate bankruptcy—eligible debts are erased. Chapter 13 is the wage-earner’s bankruptcy. You pay back your debts over three or five years, with payments based on your income. 

Bankruptcy pros

Bankruptcy can offer some advantages for people who can’t afford to get rid of debt on their own. Here are some of the potential upsides of filing for bankruptcy:

• Bankruptcy can wipe out some debts. If you qualify for Chapter 7 bankruptcy, within a few months, you could be debt-free. Chapter 7 can’t wipe out secured debts like a car loan or a mortgage. But it’s an option to consider if you have high credit card debt and you don’t own many assets that you’d have to give up.

• Bankruptcy can halt collection actions. When you file a bankruptcy petition, the bankruptcy court can issue something called an automatic stay. This tells your creditors to back off and stop collection actions while your case is pending. If your debts are eventually discharged through bankruptcy, creditors can't come back and try to collect later.

• You can avoid wage garnishments. Depending on the laws in your state, creditors might try to sue you, then garnish your wages to pay your debts. In a wage garnishment, your employer withholds some of your pay and sends it to the court instead, so it can be forwarded to your creditor. The automatic stay can stop wage garnishments, and your future earnings aren’t garnished for debts discharged (forgiven) in bankruptcy. 

• Bankruptcy can ease financial stress. Debt can take a toll on your physical and mental health. If you feel like you're at wit's end because debt collectors are calling, filing bankruptcy can ease some pressure. 

• Filing bankruptcy doesn't mean giving up all your assets. An asset is anything you own that has value, such as a bank account, your car, or your home (and everything in it). In a Chapter 7 bankruptcy, you may have to give up some of your assets (the court will sell them to pay your creditors), but every state allows you to keep some. The things you can keep are called bankruptcy exemptions. And in a Chapter 13 case, you don't have to give up any assets. 

Bankruptcy cons

Filing for bankruptcy does have some downsides that you should weigh carefully against the pros:

• Bankruptcy hurts your credit. A bankruptcy filing on your credit report will hurt your credit, and that's more or less unavoidable. However, if you've already damaged your credit standing with numerous late payments, defaults, or high credit card balances, the drop after filing bankruptcy might not be as steep as you think. 

• Bankruptcy isn’t free. You’ll pay court fees when you file for bankruptcy, unless you convince the court to waive the fees because you don't have the means to pay. Also, most bankruptcy filers hire an attorney, which adds to your costs. However, filers with attorneys have better outcomes, on average, than filers who don’t. 

• Not everyone qualifies. Before you can file for bankruptcy, you've got to prove you're eligible. Eligibility is based on how much debt you have, how many people live in your household, how much income you have, and the value of your assets.

• Not everyone successfully completes bankruptcy. About half of Chapter 13 cases fail. The required payment tends to be very high (too high for some people to afford). There’s also no guaranteed amount of debt forgiveness. It’s possible to spend more on Chapter 13 bankruptcy than you would have spent if you had just put yourself on a debt payoff plan.

Alternatives to bankruptcy

Bankruptcy isn't the only way to deal with debt. You might consider debt resolution or a debt management plan instead. 

Debt resolution is the process of negotiating with your creditors to accept less than the full amount you owe. The remaining balance is forgiven. It’s an option to consider if you mainly owe unsecured debts (like credit cards and personal loans), and a financial hardship has caused you to fall behind on payments. 

You can negotiate with creditors on your own, but you might get better results if you hire a reputable debt resolution company. They work with your creditors to reach an agreement, which can be a relief if the thought of trying to negotiate stresses you out. Professional debt resolution programs typically take 2–4 years to complete.

A debt management plan, meanwhile, is a structured plan for paying off debt. You meet with a credit counselor, who reviews your debt situation and suggests a repayment plan. 

If you agree to the plan, you make payments each month. The credit counselor spreads that payment out among your creditors. In some cases, you might get certain fees waived, or your interest rates reduced. A DMP is designed to repay all of your debts in full within 3–5 years, and you’ll typically have to give up your credit cards while you’re on the plan.

Are these perfect solutions? No, but they are viable options that could help you address overwhelming debt.

Resolving debts for less than the full amount you owe could have a negative impact on your credit profile. Not everyone qualifies for debt resolution, and if you hire a company you’ll pay fees that will reduce the amount of your savings. However, professional debt resolution companies have expertise, relationships with creditors, and systems in place that could get you better results than you could on your own. 

A debt management plan could hurt your credit score if you close your credit card accounts to enroll. Closing credit cards when you owe a balance can cause your credit utilization ratio (how much of your credit line you're using) to rise, and a high utilization ratio can hurt your score. 

Making an informed choice shows a strong commitment to turning things around. Talk to a debt expert who can help you weigh your options. Whether you go with bankruptcy or something else, you can feel confident that you're making an informed decision. 

What's next

• Read up on Chapter 7 and Chapter 13 basics to learn more about how each works. 

• If you need more info, look for bankruptcy attorneys in your area who offer a free initial consultation. 

• Research alternatives to bankruptcy and find out how debt resolution works. Debt resolution might be a more efficient strategy for getting rid of your debts.