Bankruptcy: Rarely the Right Choice

by Jason Dean 

bankruptWhen our founding fathers established the United States of America, one thing they wanted to handle differently was the treatment of debtors. In Old Europe, people who were unable to pay their debts were thrown into prisons — or in the famous case of Australia, shipped off to a debtors’ colony. The founders of the U.S. understood this to be foolish: After all, if someone cannot pay his debt on the outside of prison, he certainly won’t be able to pay it on the inside.

But more than that, the founders understood that imprisoning debtors discouraged risk taking, and that had led to low economic growth of semi-feudal Europe. The United States, they decided, would encourage risk taking. Yes, individuals would still assume personal responsibility for their investment choices, but if worse came to worse, they would be allowed the escape of bankruptcy — not an entirely pain-free escape, mind you, but a comparatively merciful discharge of their debts without prison or deportation.

Thus, personal bankruptcy became one of the building blocks of America’s wealth… But in 2005, two-hundred-plus years of history were undone with the stroke of the president’s pen. Now personal bankruptcy protection is much harder to obtain, and when it comes to Chapter 7 (traditional bankruptcy), many Americans no longer have the right at all. What happened?

Chapter 7 vs. Chapter 13

There are two main types of bankruptcy protection for individuals: Chapter 7 and Chapter 13.

Chapter 7 is what most people commonly understand to be bankruptcy. Under Chapter 7, all of your debts are discharged — as in, you don’t owe them anymore. Every state has a list of exempt assets (such as your primary car) and asset levels (i.e. $5,000 in savings), and if you exceed these exemptions, you may be forced to sell some of your property and pay your creditors, pro-rata. But for most people, this does not apply. For example, the homestead exemption in your state may be $250,000; which would mean that if your home had more than $250,000 in equity, you might be forced to sell it and pay the excess to your creditors. Very few people meet these criteria, particularly given the new “means test” for Chapter 7 (discussed below).

Chapter 13 is different. Under Chapter 13, you are allowed to keep all of your assets — even if you own two $10 million homes and a pair of Honus Wagner baseball cards, you can keep your stuff. The bad news is that your debts are not discharged. Instead, you are put on a three- or five-year program, under which you will be required to make payments to a court-appointed bankruptcy trustee equal to all of your income in excess of your “basic living expenses.” Who decides your “basic living expenses” are? The IRS; not you.

The good news about Chapter 13 is that once you’re done with your three- or five-year program, your remaining debts are discharged. Then, after seven years have passed since you first filed bankruptcy, the black mark of Chapter 13 is taken off your credit report. Chapter 7, by contrast, stays on your credit report for an entire decade.

So Which Should You Choose?

In most cases, you no longer have a choice. Under the new law, individuals with household income in excess of the state median are forced to file Chapter 13; and in most cases, individuals with income less than the state median are forced to file Chapter 7 (even if they want to file Chapter 13). In other words, if you make more than the average family in your state, you cannot file Chapter 7.

It’s also important to note that there are various exempt creditors. For example, student loans are not dischargeable, and neither are child support or back taxes. Under a Chapter 13 plan, your student loans, child-support, and back-tax payments may be reduced for the three- or five-year period of your plan, but at the end of that period, you will still owe what you actually owe.

Better Alternatives

Only under the most extreme cases is bankruptcy your best option. Usually, it’s better to simply deal with your creditors. If you tell them you are having trouble making payments, they will normally work with you. After all, they lose out if you ultimately file bankruptcy, even if it is Chapter 13.

Alternatively, there are numerous debt-consolidation, debt-management, and credit-counseling services that individuals burdened by debt can utilize to improve their situations. The new bankruptcy laws may be unfair and counterproductive, but fortunately, there’s more available support for debtors than ever before. Good luck!

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