The Bankruptcy Solution

Discharging your debts by filing for Chapter 7 or Chapter 13 can wreck your credit, but it offers a fresh start.

Stephanie Monson was horrified when she learned that her husband had racked up more than $45,000 in credit-card bills. The debt forced Monson to file for personal bankruptcy -- and led to the couple's divorce.

With the help of an attorney, Monson filed for Chapter 7, a process that wipes the debt slate clean but also requires the liquidation of major assets. In the end, Monson's massive mound of credit-card debt was forgiven. And because she wasn't behind on her mortgage payments, her lawyer worked out a payment plan with her lender that allowed her to keep her home.

Getting out from under all that debt was a relief, but two years later the consequences continue to resonate. "My sterling credit rating went down the drain," says Monson, a mother of three who is an academic adviser at the College of St. Scholastica, in Duluth, Minn.

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The experience made Monson reassess her personal finances in a way she never thought she'd have to. She recently started using budgeting software to track her spending and get a feel for where her money is going. She now has only one credit card, which she pays off every month. Monson says she's taken all these steps because "I need to be an example for the kids."

As more people start to veer off financial course, Monson presents a reassuring example of how to slowly and deliberately rebuild a fiscal foundation after a financial crisis.

Spreading Financial Pain

Falling home prices, a swooning stock market and sky-high levels of consumer debt have left many Americans little choice but to consider personal bankruptcy. Filings rose more than 30% last year compared with 2007, to 1.1 million, according to the American Bankruptcy Institute, a research and education organization. Filings are likely to increase by another 35% in 2009, according to an ABI poll.

The pain is spreading: In the past, personal bankruptcy was mainly the province of lower-income families. Now credit counselors and bankruptcy lawyers report that more and more upper-income households are being pushed to the brink by one or more financial crises -- unaffordable home payments, job loss, divorce or a major illness that insurance doesn't cover. Laura Margulies, a consumer-bankruptcy attorney in Rockville, Md., says that until recently she was dealing with construction and real estate workers who had fallen on hard times. Now she is receiving inquiries about filing from people in all walks of life.

As a rule, personal bankruptcy should be a last resort. But as Monson discovered, there are ways of navigating the rough waters of bankruptcy that make it easier to emerge on the other side, better positioned to make a fresh start.

Tougher Bankruptcy Standards

If you're considering bankruptcy, the first thing to do is hire a lawyer. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made filing far more complex, so you should find an attorney who specializes in consumer bankruptcies (check the Web site of the American Board of Certification). Under the new law, passed after heavy lobbying by credit-card companies and other lenders, you'll have a tougher time proving that your financial straits are truly dire. To qualify, you have to provide more paperwork and meet stricter standards.

As a consumer, the two main types of bankruptcy available to you are Chapter 7 and Chapter 13. (If you owe more than $1.3 million, you can enter into Chapter 11.)

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By far the most common form for individuals is Chapter 7, which essentially amounts to a liquidation. If you've lost your job, are overwhelmed with debt and earn less than the median income, you most likely will file for this type of bankruptcy. Your assets -- possibly including your house -- are sold and the proceeds are divided among your creditors.

Chapter 7 gives you a clean slate because all IOUs -- with the exception of taxes, child support and student loans -- are discharged. To qualify, you must undergo a "means test"; you can file if you earn less than the median income for a family of similar size in your state. In Maryland, for instance, you must earn less than $53,489 as an individual or less than $71,000 as a two-person family. The U.S. Census Bureau tracks the median family income on a state-by-state basis.

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If you are drowning in debt but have a job, you may qualify for Chapter 13. Those who file for this type of bankruptcy typically earn more than the median family income. You have to have discretionary income, which can include income from a job, self-employment or a family member who agrees to help out.

Consumers facing foreclosure who want to keep their home are the largest group of Chapter 13 filers. Chapter 13 may also work for you if you owe back taxes, child support or student loans, which wouldn't be eliminated by a Chapter 7 filing. Under Chapter 13, your attorney proposes a three- to five-year repayment plan to the court that outlines who gets paid each month.

If you qualify for both Chapter 7 and Chapter 13, your financial priorities will help determine which type you should file. One of the key factors in the decision is whether you want to keep your home. With so many homeowners "upside down" on their mortgage -- meaning they owe more than their house is worth -- some want to start fresh, even with the hit to their credit score. In that case, Chapter 7 would be the more attractive option.

Before you file for bankruptcy, you must see a counselor at a credit-counseling agency that has been approved by the U.S. Department of Justice. Some agencies charge for the initial session, but they'll waive the fee if you ask for an exemption prior to the session.

Then, after you file for bankruptcy, you must complete a debtor-education course intended to teach you how to budget your money and use credit carefully. The debtor-education provider, who will charge a fee between $50 and $100, must also be approved by the Justice Department. You can find a state-by-state list of qualified credit counselors and debtor-education agencies at the Justice Department's Web site.


Relief for Homeowners

If you're considering filing for personal bankruptcy because you're having trouble making the mortgage payments on your primary residence, keep an eye on the so-called cram-down bill. The measure, which is part of President Obama's housing plan and is making its way through Congress, would allow bankruptcy judges in Chapter 13 proceedings to reset the terms of certain mortgages so that more homeowners can keep their homes.

The move would be a big change. At the moment, a Chapter 13 filing stops the foreclosure process and gives homeowners time to restructure their payments with their lender. But as the law currently stands, you don't have the ability to alter the terms of your loan.

Under the new measure, as passed by the House of Representatives, the judge can reduce your principal and interest rate. Say you have a $400,000 loan on a home whose value has fallen to $300,000. Under the plan, a bankruptcy judge could eliminate $100,000 of the debt, says Yardeni Research. Before you could qualify for a cram-down loan modification, you would have to show that you appealed to your mortgage lender for relief at least 15 days before you filed for bankruptcy.

While the plan would help more people keep their homes, the mortgage industry opposes it because of concerns it will destabilize the housing market and lead to more bankruptcy filings. Opponents worry that more homeowners in danger of foreclosure will file for bankruptcy (and live with the hit to their credit) if that's a surer route to keeping their homes.

Should You File Bankruptcy?

Perhaps the most far-reaching consequence of filing for bankruptcy is the impact on your credit. A bankruptcy filing stays on your credit record for seven to ten years, says Steven Katz, director of consumer education at, the consumer branch of the credit bureau TransUnion. While the impact on your credit score depends on your individual situation, some bankruptcy lawyers say it could take a hit of 100 points.That's why the decision to file is not one that you should take lightly.

In fact, if you're starting to feel overwhelmed with debt, it's a good idea to seek credit counseling before payments get out of control. "If you catch things early enough, you may not have to file for bankruptcy," says Bruce McClary, media-relations coordinator and a certified counselor for ClearPoint Financial Solutions, in Richmond, Va. You could also tap the free information and budgeting tips on the Web site of the American Financial Services Association, the trade group for the consumer credit industry.

The Federal Trade Commission says the number of individuals approaching credit counselors has jumped by more than one-third recently. In some cases, your credit counselor can work out a repayment plan with your creditors. Your lawyer may also be able to negotiate a deal with lenders.

In the end, if there is no other way out, be sure you don't get sucked into a credit-counseling scam. Such schemes are becoming more common in the down economy.

Associate Editor, Kiplinger's Personal Finance