We all know that filing for bankruptcy is a major decision that should be carefully considered. So it makes sense that folks facing overwhelming debt often second guess whether they have enough debt for bankruptcy to be the right solution.
In this blog, we discuss how you can decide whether you have enough debt to file bankruptcy and what signs are often present when bankruptcy makes sense for your financial situation. We also explain how your debt will be categorized in bankruptcy and how the type of bankruptcy you file will impact how much debt will be erased if you file bankruptcy.
Outline:
Types of Debt
It's important to understand debt is treated differently in bankruptcy depending on the type of debt.
Secured Debt
Secured debts are debts that are attached to specific property, known as collateral, which can be seized by the lender in case of default. Examples of secured debts include home mortgages and car loans. If the borrower fails to make payments, the lender can recover their security interest (i.e. foreclose/reposes the property) to recoup their money.
A quick "smell test" to determine if a debt is a secured debt is to ask yourself if the lender can take any property from you because you failed to pay them for the property.
Unsecured Debt
Unsecured debt isn't directly tied to any collateral. This means that the lender cannot automatically repossess any property if the borrower defaults. The most common examples of unsecured debts include credit card debt, medical bills, and personal loans.
How Debt is Treated Differently Bankruptcy
Individuals (i.e. not businesses) have two main options when considering bankruptcy: Chapter 7 bankruptcy or Chapter 13 bankruptcy. It's important to understand how these types of bankruptcy treat debt differently before deciding if bankruptcy is the right solution for you.
What Debts are Erased in Chapter 7 Bankruptcy
Most unsecured debt gets erased in Chapter 7 bankruptcy. Those unsecured debts that we call "priority unsecured debts" don't get erased, however, and you'll be left still owing those at the end of your bankruptcy. Common examples of priority unsecured debts include child support, alimony, certain unpaid taxes, and certain debts arising from driving under the influence.
Secured debts don't get eliminated in Chapter 7 bankruptcy. It's important to understand that in order to keep the property that serves as collateral for your secured debt, you need to make sure two things are true before you initiate bankruptcy proceedings: (1) you need to make sure you can exempt all of your equity in the collateral and (2) that you're current on your payments. If you're behind on payments for any of your secured debt, the creditor is free to recover the collateral from you after they get approval from the bankruptcy court.
Chapter 7 bankruptcy is technically a liquidation bankruptcy because the trustee liquidates (takes and sales) any real estate, personal property, and/or financial assets that can't be protected using bankruptcy exemptions. After the trustee liquidates the non-exempt property, they distribute the proceeds to creditors on a "pro rata" basis. You'll sometimes hear Chapter 7 bankruptcy referred to as a straight bankruptcy due to this, because it's typically straight-forward and transactional as far as how property is handled. The process typically lasts a few months, and at the end, the debtor receives a discharge of most unsecured debts, such as credit card debt and medical bills.
What Debts are Erased in Chapter 13 Bankruptcy
The unsecured debt that you don't repay through your Chapter 13 repayment plan is erased at the end of your bankruptcy. However, you don't get to just decide that you don't want to repay some or all of the unsecured debt. Your Chapter 13 repayment plan is determined after a thorough review of your entire financial situation, and the amount of repayment that unsecured creditors receive in a Chapter 13 bankruptcy is usually tied directly to the specific financial situation of the debtor(s). This means that the amount of repayment that unsecured creditors receive varies from bankruptcy to bankruptcy based on the means of the individual debtor(s). It also means that unsecured debt is commonly discharged in a Chapter 13 bankruptcy, but after a longer period of time and usually some repayment.
Secured debt doesn't get erased in a Chapter 13 bankruptcy either, although in some bankruptcy cases there are some interesting ways to reduce the overall amount of secured debt owed by converting some of it into unsecured debt. For example, in some situations it's possible to convert the negative equity in a car into unsecured debt and reduce the secured portion of the debt to an amount equal to the fair market value of the vehicle. It's also possible sometimes to convert second and third liens on homes into unsecured debt if there isn't enough value (using fair market values) in the home for the lien to attach to. For example, if there's a mortgage for $200,000 and a HELOC for $35,000, but the value of the home is only $189,000 then there wouldn't be enough actual value in the home for the HELOC to attach to and the $35,000 could potentially be converted to unsecured debt.
Another key feature about Chapter 13 bankruptcy is the debtor's ability to catch up on payments for secured debt. Folks who are behind on payments for secured debt for property (aka "collateral") they want to keep can avoid foreclosure and repossession by filing a Chapter 13 bankruptcy. The total amount the debtor is behind (aka "arrearage") gets placed in the plan and paid off over the three to five years, which means in practice that the debtor repays the arrearage by breaking it into 36 or 60 payments.
As already discussed, Chapter 13 bankruptcy involves a repayment plan. Debtors with a steady income propose a plan based on their specific financial situation to repay their debts over a period of three to five years. A bankruptcy trustee is appointed to oversee the repayment process, and a bankruptcy court monitors the case. The debtor makes monthly payments to the bankruptcy trustee, who then distributes the funds to the creditors according to the approved plan.
What Happens When Debt is Discharged in Bankruptcy
The bankruptcy code allows personal loans, credit card debt, medical bills, and other unsecured debts to be discharged in Chapter 7s and in many Chapter 13s (see above). This means that the borrower is no longer legally obligated to repay these debts. Keep in mind, however, that not all unsecured debts are dischargeable. For example, student loan debt is generally not dischargeable, unless the borrower can demonstrate to the court that repayment would cause undue hardship. Similarly, debts arising from criminal fines, child support, and certain types of tax debts are examples of priority unsecured debts and typically non-dischargeable.
A bankruptcy discharge is the legal release of the debtor from personal liability for certain debts. The discharge provides individuals with a fresh start, allowing them to rebuild their financial lives. It is granted by the bankruptcy court, and once discharged, creditors are prohibited from taking any further action to collect on those debts. Folks who attempt to collect on debt discharged in bankruptcy violate federal and state law and can and should be sued.
How Much Debt is Worth Filing Bankruptcy
You should consider filing for bankruptcy if you're overwhelmed by debt that you cannot realistically repay in the next three to five years. There isn't a magic amount of debt that makes bankruptcy make sense in every case. Every person's financial situation is different, causing the amount of debt that's "worth" filing bankruptcy to vary based on different factors such as amount and type of debt, family size, income, expenses, and working ability.
If you're considering bankruptcy it's important to honestly calculate your average monthly income and average monthly expenses, not including your unsecured debt. It's important to be thorough and realistic when calculating your average monthly expenses. Make sure you're not overlooking anything and make sure that you include necessities that come up but are often overlooked when budgeting, like copays, new shoes and clothes for the kiddos, and enough money to actually afford groceries and gas. Once you've done this you'll know how much money you have left over to put toward your debt. If that's not enough money for you to repay your debt in the next three to five years then you can't afford to repay your debt in that amount of time.
Depending on how close or far from repaying your debt that your new budget (yes, you just created a budget) tells you you'll be in three to five years, you can decide if you have enough debt for bankruptcy to be worth it. If you don't have enough money left in your budget to make on time payments that are more than the minimum payment (ideally they should be at least minimum payment + interest), then talking to an Austin bankruptcy lawyer to seek professional advice from our bankruptcy attorney makes sense.
Signs That You May Need to File for Bankruptcy
There are several signs that may indicate bankruptcy as a necessary solution to overwhelming debt. Here are a few indicators to consider.
Constant Creditor Harassment
If you find yourself receiving frequent calls, letters, or legal action from your creditors, bankruptcy may provide relief and put an end to the harassment.
One of the immediate benefits of filing for bankruptcy is the automatic stay, which puts a halt to any collection activities by creditors. This means that creditors must stop all collection attempts, including wage garnishments, lawsuits, and foreclosure proceedings, providing debtors with temporary relief to assess their financial situation and explore bankruptcy as a debt relief option.
Consistent Late Payments
Falling behind on debt payments will show up on your credit report and negatively impact credit scores, making it even more challenging to obtain new credit or loans. If you find yourself in a cycle of late payments, bankruptcy may provide an opportunity to start fresh and rebuild credit.
Overwhelming Medical Bills
Healthcare costs can quickly add up, leaving individuals with unmanageable debt. If medical bills are becoming a financial burden, filing for bankruptcy may help alleviate the pressure.
Inability to Meet Basic Expenses Without Credit
If you don't have enough disposable income and you're struggling to pay for essential living expenses, such as rent or utilities, bankruptcy may offer a fresh start by eliminating or restructuring unsecured debts.
It's so common to hear folks explain a debt cycle where they get paid, pay their monthly expense and make minimum payments on all their debt, only to end up not having enough money for gas and food at the end of the month, so they have to use their credit cards to make ends meet. This cycle is a trap because folks effectively undo their debt payment when they use the credit cards later in the month. They basically take one step forward and then one step back each month.
When Debt Repayment is Impossible
After creating your budget (see above), it becomes clear that debt repayment is simply not feasible, bankruptcy may be the best course of action.
Seeking Professional Help
If you're considering personal bankruptcy, seeking professional help from an Austin bankruptcy attorney is the best way to ensure you get the relief you want from your bankruptcy filing. An Austin bankruptcy lawyer and their team can provide specific advice, guide you through the legal process, and ensure that your rights are protected. Its important to have a professional by your side who knows more than just the bankruptcy basics and who is knowledgeable of bankruptcy law, the federal bankruptcy courts and trustees, and the complexities of the legal system.
Conclusion
Ultimately, the decision about whether you have enough debt to file bankruptcy is a decision that only you can make. You need to review various factors, such as, your income, expenses, the type of debt you have, and what your future earning potential looks like. You'll also want to consider how debt is treated differently in a Chapter 7 bankruptcy vs Chapter 13 bankruptcy. There are often certain signs that are common among folks who inevitably file bankruptcy and end up being very happy that they did. The bankruptcy process is nuanced and is more involved than just preparing a bankruptcy petition, and hiring a bankruptcy lawyer to help protect you and guide you through the process is one of the smartest ways to begin your journey to a fresh start.
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