Consumer Bankruptcy Basics Part II: The Drawbacks of Personal Bankruptcy

Last week I introduced this series of posts on consumer bankruptcy with a description of the primary benefits of filing bankruptcy.  This week we discuss a couple of the reasons that bankruptcy may not be the right choice for many individuals.  Specifically, I am going to focus on the effects bankruptcy has on your credit and the distribution to creditors.

As we all know, the world runs on credit.  A retail store is more likely to take Visa than a check these days.  It is, therefore, important to most individuals that they have decent credit and have at least one major credit card.  Much of what determines your creditworthiness is your FICO Score. Your FICO score is based on a scale of 300-850.  I do not purport to be an expert on credit agencies or scores, and there are plenty of websites out there that can give you much more information on those subjects.  Suffice it to say, however,  a bankruptcy filing can decimate your credit score and will generally stay on your credit report for 10 years.  A recent Baltimore Sun article notes that a bankruptcy filing can lower your Vantage Score (FICO's primary competitor score on a scale of 501 to 990) by 355-365 points.  While it certainly is not impossible to get credit after you file for bankruptcy, it is definitely a lot more difficult for the average consumer.  It's worth noting though, that if you are already considering bankruptcy, your credit score is likely on the decline in the first place--and, because all your debts will be discharged in bankruptcy (see last week's post), you know your score can't go much lower once you receive your discharge.

The other drawback of filing bankruptcy is the distribution of the bankruptcy estate to creditors.  My post next week will focus in much greater detail on the mechanics, but essentially, once you file for bankruptcy, a "trustee" is appointed to manage the "bankruptcy estate."  In Chapter 7, this means that a trustee will liquidate a debtor's assets and distribute them to creditors.  In Chapter 13, this means that the debtor will have to continue making payments to creditors for 3-5 years.

Despite what i just said, don't let my statement that a trustee will liquidate assets scare you.  Two types of assets will not get liquidated, and most consumer debtors often only have assets of these types.  The first of these are encumbered (mortgaged) assets.  Things like your house and car, assuming you don't have very much equity in them, will not get liquidated.  Don't get me wrong, they can still be foreclosed, but because the bank has first crack at them, they will not be part of the bankruptcy estate so long as there is not enough equity for anything to be left over if the bank forecloses.  So, if you keep making your loan/mortgage payments during and after bankruptcy, you will usually be able to keep your car and house.

The other type of assets that are protected from liquidation are exempt assets.  The Bankruptcy Code (the volume of U.S. law governing the bankruptcy process) permits debtors to exempt certain items from the reach of creditors and the trustee.  The exemption scheme is very complex, but without getting into too many details, depending on the state they live in, debtors can usually exempt specific assets including retirement accounts, at least some equity in a primary residence, and other items that the law deems to be too important to give up to creditors.  Given some time, a bankruptcy attorney will often be able to figure out out to exempt most unencumbered assets for the average consumer debtor in financial trouble.

As was the case in last week's post about benefits of bankruptcy, there are obviously other drawbacks to filing for bankruptcy than those I've mentioned, but these are two big ones.  My next two posts will focus on the two types of bankruptcies available to most individual debtors: Chapter 7 and Chapter 13.

Remember, this series of posts is not intended to be legal advice or a primer on how to file bankruptcy and navigate the process but rather a plain-English description of the process and the options available.  Always consult a competent attorney before making decisions about taking legal action.