When bankruptcy is best

By Liz Pulliam Weston

The bills are piling up. The collection agencies are calling. At night you lie awake, wondering how you're ever going to cope with your debts.

At what point does it make sense to throw in the towel and file for bankruptcy?

There's no one-size-fits-all answer to that question. In purely financial terms, the answer depends on:

• Your current situation.
• Your future prospects.
• The laws in your state.

There is, of course, another factor to be weighed, which is your personal sense of responsibility for repaying the debt you've incurred. We'll get to that in a moment.

For now, let's explore the purely financial and legal aspects of bankruptcy.

How the process works

A bankruptcy filing halts, at least temporarily, all collection activities, from phone calls demanding payment to more serious actions including foreclosure, wage garnishment and levies against your bank accounts.

What happens next depends on the type of bankruptcy you file:

• In the most common type of filing, Chapter 7, your credit card balances, medical bills and most other unsecured debts are erased entirely. (Certain other unsecured debts, like student loans and recent taxes, typically can't be wiped out in bankruptcy.) Technically, some of your property could be taken and sold to satisfy your creditors; the types of property that could be taken vary by state. In some states, for example, only a small amount of home equity is protected from creditors, while in others like Florida and Texas the amount of equity that can be sheltered in a home is virtually unlimited.
• In Chapter 13 filings, you're allowed to keep property that might otherwise be used to pay your creditors. In return, you agree to a plan to repay at least some of your debts over the next three to five years. If you complete the plan, the remainder of your eligible unsecured debt is legally erased.

Under the federal bankruptcy reform legislation that took effect last year, you may be required to submit to a "means test" if you file for Chapter 7 and your income exceeds the median for your area. If the means test determines you can afford to repay some of your debt, you'll be shunted into a Chapter 13 repayment plan.

Either way, your credit will be devastated for a while. Bankruptcy is the single worst thing you can do to your credit scores, the three-digit numbers lenders use to gauge your creditworthiness. That means, for a time at least, it will be more difficult and expensive for you to get credit.

Restoring your financial life

But bankruptcy also can give you a fresh start by wiping out old, troublesome debt. Rather than struggling to repay your bills for years or even decades, you can get started rebuilding your financial life. Those who get their act together and begin using credit responsibly often find that they can restore their credit scores to near-prime levels in just a few years. (Read "Bounce back fast after bankruptcy" for more details.)

In fact, the financial benefits of this fresh start are so profound that some experts say we shouldn't be surprised that so many households file for bankruptcy. Rather, we should be amazed the numbers aren't higher.

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Back in the late 1990s, when about 1% of U.S. households were filing bankruptcy annually (compared to 1.8% last year), University of Michigan researcher Michelle J. White discovered that at least 17% of U.S. households would be better off financially if they filed. The percentage would balloon to nearly half of U.S. households if more people "prepared" for filing, by doing things like maxing out their available credit limits and transferring vulnerable property, like cash in the bank, into bankruptcy-exempt retirement funds.

Relatively few people game the system that way, however. Most arrive in bankruptcy court after exhausting every other avenue they can think of to pay their bills, according to Harvard University professor and bankruptcy expert Elizabeth Warren.

That's borne out by a recent survey from the National Foundation for Credit Counseling. The organization polled its member agencies, which provide newly mandated counseling to consumers before they file for bankruptcy, and discovered only about 3% of those in pre-filing counseling had the means to repay any of their debt.

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