1. "Personal bankruptcy's not just for the poor."
Linda Frakes, an entrepreneur in Georgia, built a life around her six-figure income. But when her new business collided with the credit crunch, Frakes found herself facing a financial fate she'd never anticipated. "It's a far way to fall," she says.
Meet the new face of bankruptcy. This nation's worst downturn in 70 years pushed more formerly affluent people into bankruptcy than in previous recessions. Overall, personal bankruptcy filings were up 36.5% in the first half of 2009 from the same period the previous year, and experts predict the number of filings will keep rising even as the economy recovers.
Leslie Linfield, the executive director of the Institute for Financial Literacy, calls it "a middle-class recession": Last year the institute surveyed likely bankruptcy filers and found that 8.1% made more than $60,000, up from 6.9% in 2007. Experts blame the increase on slumping real estate prices and job losses, which have cut deeply into professional positions. Claire Ann Resop, a bankruptcy attorney in Madison, Wis., sees a lot of mortgage brokers and real estate developers: "They made a lot of money, and now they can't."
2. "When it comes to bankruptcy, one size doesn't fit all."
No type of bankruptcy will eliminate certain kinds of obligations, like child support, alimony and most student loans. But there are differences in the way debt gets handled in personal bankruptcy, often depending on whether you file for Chapter 7 or Chapter 13. Each has pros and cons.
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How do you know which form is right for you? Bankruptcy law is complex, and provisions vary from state to state, so it's often best for potential filers to consult an attorney before deciding.
3. "We don't want your house if we can't get good money for it."
A common belief about bankruptcy is that it will leave you with nothing, living out of a cardboard box, says Cathleen Moran, a bankruptcy lawyer in Mountain View, Calif. But that's not necessarily true, even in Chapter 7 cases. In theory, Chapter 7 involves liquidating most of a debtor's assets to pay creditors, including the home. But in reality, homeowners who end up filing often don't have enough equity in their home to benefit creditors, either because they've taken out a second mortgage or the home's value has fallen, or both. In such cases, the trustee handling the bankruptcy can decide not to liquidate the home, in which case the debtor gets to keep it.
Also, there's something called the homestead exemption, which in most circumstances allows you to keep your primary residence if your equity in it is below a certain threshold. It can vary widely from state to state: from $30,000 for a married couple filing Chapter 7 in Illinois, for example, to $75,000 for the same in California. But since Chapter 7 tends to delay, rather than stop, foreclosure, those who are behind on their mortgages often lose their homes regardless.
4. "This could actually improve your credit scores down the road."
Yes, bankruptcy will pummel your credit scores, says Barry Paperno, the consumer-operations manager for FICO, the company that develops the credit scoring formula used by the three major credit bureaus. Yet bankruptcy can be less damaging in the long run than juggling late payments on credit cards for years in a bid to postpone the inevitable. Bankruptcy stays on your credit report for 10 years, but you can begin repairing it immediately, if gradually.
Most people have a history of lousy credit when they go bankrupt. Yet they are able to return to (and maybe surpass) their pre-bankruptcy FICO score more quickly than the rare debtor with pristine credit who needs to file bankruptcy after, say, a serious illness -- which could mean a credit score drop of 100 points or more, Paperno says. Since 35% of a person's credit score is based on payment history, the further consumers get from any missed payments, the more their score improves, he says.
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How to speed the recovery? Establish new credit as soon as possible, Paperno says, either through a new credit card or car loan, though bankruptcy filers will have to pay higher interest rates. (See "Bounce back fast after bankruptcy.")
5. "Debt settlement firms may do more harm than good."
Debt settlement firms offer to play hardball with creditors and whittle outstanding balances by as much as 75%. They bill their services as an alternative to bankruptcy, but in many cases they can hurt more than they help. Debt settlement firms are unregulated, for-profit entities that require regular payments before taking any action on a consumer's behalf. This business model works squarely against debtors' interests, says Walter Benenati, a bankruptcy attorney in Orlando who worked briefly for a debt settlement firm. "They're getting fees every month, so they have no incentive to settle (with creditors) as fast as possible," he says.
In fact, you don't need a middleman to negotiate with creditors. But, says Mariana Bekker, director of media relations for the United States Organizations for Bankruptcy Alternatives, a debt settlement trade organization, most debtors don't have the "time, stamina or desire" to do it themselves. Either way, you'll owe taxes on any amount saved on your debt. (That's right: The IRS considers forgiven debt taxable income.)
Debt erased as part of bankruptcy, by contrast, isn't taxed.
Continued: More secrets of filing for bankruptcy
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