Thinking About Bankruptcy?

If you're feeling like your debts are spiraling out of control, you're not alone: Nearly 1.2 million people filed for bankruptcy last year. Unfortunately, many of them filed without fully understanding the repercussions of bankruptcy -- and some of them would have been better off not filing at all.

"People should really only consider filing for bankruptcy as a last resort," says Andrew Schrage, the founder of personal finance website MoneyCrashers.com. "Filing for bankruptcy will have a negative effect [on your life] for years to come."

Still, some people need to file for bankruptcy. To help you determine whether you're one of them, we asked bankruptcy attorneys to explain what you should know before you file.

Types of bankruptcy

There are two main types of personal bankruptcy: Chapter 7 and Chapter 13. Chapter 7, the most common, wipes out most of your debts, so you will no longer have to pay the creditors.  You are typically eligible to file Chapter 7 if your median income is below that of a family of your size in your the state. Even if it isn't, you may still qualify by showing that after paying for basic needs, like food and housing, you do not have enough income to pay most of your unsecured debts. That includes things like credit card and medical bills and personal loans (this will be determined by a "means test," which varies from state to state).  If you aren't eligible for Chapter 7, you may have to file Chapter 13.

In the second type of bankruptcy, Chapter 13, you must follow a strict plan in which you repay some or all of your debt within a three- to five-year period. The amount you repay is based on what you can afford. At the end of the repayment period, the remaining debt you owe may be discharged.

A lot of people who have fallen behind on the payments for their house or car use Chapter 13 as a way to stop a foreclosure or save their car [from repossession], says John Hargrave, the founder of bankruptcy firm John Hargrave & Associates in Barrington, N.J.

Consequences

Filing for bankruptcy has some positive consequences -- most notably that many creditors can no longer come after you for old debts. The calls will stop. You can eat dinner without being bothered, says Mark Billion, founder of bankruptcy law firm Billion Law in Wilmington, Del.

However, myriad negative outcomes could outweigh the positives. Bankruptcy can lower your credit score, meaning lenders may not give you a loan or line of credit, or if they do, it may prove costly.  Some people file for bankruptcy and then get credit card offers within six months, but the rates are high, Billion says. Furthermore, six in 10 employers say they check at least some prospective employees credit reports to help make hiring decisions, according to a study by the Society for Human Resource Management. Those with bad credit scores may not be hired.  Plus, the bankruptcy filing will be made public, so anyone can find out that you declared bankruptcy.

Finally, though bankruptcy promises you a clean slate from your debts, not all of your debts will be discharged.  For example, you will likely still be required to pay past tax, student loan, child support and alimony payments.

Alternatives

Not everyone who is struggling with debt should file for bankruptcy, explains Stephen B. Kass, the founder of New York City-based The Law Offices of Stephen B. Kass, a firm that focuses on bankruptcy and tax.  First, "seek debt counseling if you're feeling financially strapped," Kass recommends. Debt or credit counselors can provide you with guidance on how to pay down your debts smartly and help you negotiate lower interest rates or reduced fees.

You should also consider debt settlement, says Billion, in which a company helps you "settle" your debt for some amount lower than the previous balance owed. For example, you may owe $15,000, but once you settle, your creditor will agree to take just $8,000.  The creditors get more money if they settle than if you file bankruptcy, so they're often willing to settle, says Atlanta-based attorney Bruce Ailion, who works for real estate firm RE/MAX.   Then you can avoid bankruptcy.