The Cons of Bankruptcy… and Why Many Aren’t as Bad as They First Appear
Even though bankruptcy can get you moving in a positive direction, that doesn’t mean it’s not without its downsides. However, our expert argues that many of those downsides are not as bad as they first appear.
Bankruptcy Downside #1: Your credit score will take a hit
Filing for bankruptcy creates a negative remark on your credit report. For Chapter 13, the negative item sticks around for 7 years from the date of filing. For Chapter 7, that extends to 10 years from the date of filing.
But this doesn’t mean that you will be forced to put your financial life on hold for a decade. In fact, you’ll recover much sooner than you expect. The “weight” of negative credit report items on your credit score decreases over time. So, the further you get away from a negative item you incurred, the less impact it has. And past negative items can be offset with positive actions moving forward. So, you can take steps to repair the damage and rebuild your credit.
Rhode also says the credit damage caused by bankruptcy is many times less than what consumers facing financial hardship incur if they don’t file. The evidence comes from an empirical data study by the Federal Reserve of New York in 2015. Essentially, if you try to muddle along and solve your problems on your own, you end up taking more credit score damage than you would have if you just bite the bullet and file.
Bankruptcy Downside #2: Not all debts may be discharged
There are certain debts that almost never get discharged, such as back child support or alimony. Tax debt is also not easily discharged, although it depends on the type of tax debt and your situation.
There’s also a common misconception that student loan debt can’t be discharged, even if it’s private. But our expert disagrees.
“Some federal student loans and many more private student loans can be discharged through bankruptcy,” Rhode says. “But many people don’t try because they buy into the myth. In truth, large parts of private student loans are not protected in bankruptcy, because trade or vocational programs were not Title IV qualified.”
The reason the myth exists is that the federal government did put in some protections for student lenders during consumer bankruptcy filings. The idea was that the government didn’t want people running up student debt that they had no intention to repay. The protections extended, not only to federal loans but also private loans as long as the education provided was Title IV qualified.
But this leaves a big loophole for borrowers that lenders would prefer that people didn’t know. Namely, there’s no harm in trying to get your student loan debt discharged. Even if the education was Title IV qualified, discharge is still possible in cases of extreme financial hardship. So, it’s worth it to at least ask for discharge.
Bankruptcy Downside #3: New financing may be a challenge
The common conception with bankruptcy is that you’ll become a credit pariah. You’ll be placed on a blacklist and traditional lenders will steer clear. But most of this fear is rooted in myth.
- There is no such thing as a credit blacklist.
- Although it may be tough to qualify for traditional prime loans and credit cards, there are other lending alternatives.
In other words, there are ways to get by as you rebuild credit and work to recover good credit. You can still buy a car and can even get yourself mortgage-ready in a short amount of time. And if you need credit cards, you can use secured credit cards if you can’t qualify for unsecured cards.
Rhode also explains that getting credit after you file often easier if you file for Chapter 7. “Chapter 7 filers have a greater opportunity to acquire unsecured credit from new lenders than Chapter 13 filers do. The rebound in new credit cards occurred more slowly for Chapter 13 filers, possibly because they were using a portion of their income to pay down old debts and because they can file for bankruptcy again more quickly than Chapter 7 filers can.”
Bankruptcy Downside #4: Cosigners are not protected
Cosigners and guarantors aren’t protected from collection on debts that you discharge through personal bankruptcy. So, you can get off the hook, but a loved one may get harassed over the remaining balance on a discharged debt unless you pay it off. This isn’t guaranteed to happen, but it’s definitely something to keep in mind.
Just make sure to talk to anyone that cosigned a loan with you before you file. Let me them know that you plan to file, so you can decide together how to handle the situation. Again, it’s not guaranteed that the lender or collector will pursue collection with them after a bankruptcy discharge, but it is a possibility.
The cons of Chapter 7 vs Chapter 13
If you’re choosing to file for bankruptcy, Steve Rhode recommends that you should always try for Chapter 7 first. The perceived downside of Chapter 7 is that it liquidates assets to repay your debt. That can make it seem like you’re about to lose everything. But Rhode says that’s usually not the case.
“A very, very small minority of Chapter 7 bankruptcy filers ever have to liquidate any asset,” Rhode says. By definition, Chapter 7 bankruptcy does liquidate assets to give you the fast, fresh start that it offers. But most people who file for Chapter 7 either don’t have any assets that can be liquidated OR their assets are low enough in value to qualify for exemption. So, the idea of losing everything in Chapter 7 is often really just a paper tiger.
By contrast, the con of Chapter 13 is real-time. When you file for bankruptcy, you’re doing it to get a clean break and fresh start. But that isn’t really what you get with Chapter 13. Instead, you end up on a repayment plan that can last anywhere from 3-5 years. This is roughly the same amount of time that a debt management program takes to complete. And it’s longer than the average debt settlement program, which takes 24-48 months, on average.