Imagine being able to walk away from your debt and start over with a clean slate. That's the picture proponents of Chapter 7 bankruptcy like to paint. Unlike Chapter 13, in which you repay at least a portion of your debt, Chapter 7 is a personal liquidation. You'll wipe out your unsecured debts, which include medical and credit card bills, but you'll give up your major assets (think automobiles or your home) in the process.
If you don't have many assets and you're drowning in bills, it's easy to see the appeal of Chapter 7, but you should know that declaring bankruptcy comes with serious repercussions.
It costs money to file for bankruptcy
It's ironic that when you have bills you can't pay, you need to pay to get out of that predicament, but that's how the system typically works. While the cost of filing Chapter 7 varies, expect to spend about $1,500 on filing and attorney fees. And if you think you can save money by skipping the lawyer, think again. The bankruptcy code is extremely complex, and navigating it without an attorney is sort of like hurtling down a snow-topped mountain with a broken pair of skis -- you might survive, but you're bound to get battered along the way.
It'll stay on your record for 10 years
Not only can Chapter 7 bankruptcy obliterate your credit score, but it'll remain on your credit report for 10 years. During that period, you run the risk of being denied for every loan you apply for or getting approved at absurdly high rates. Imagine you're looking at a $12,000 auto loan. Someone with a good credit might snag a 3% interest rate and pay $215 per month over five years, or $900 in interest over the life of the loan. Meanwhile, a person with mediocre credit might get approved at 6%, resulting in a monthly payment of $232 and $1,900 in interest. But with a bankruptcy filing on your record, you could easily be looking at, say, 12% interest, which would mean a monthly payment of $267 and $4,000 in total interest payments.
It won't eliminate all of your debt
Not all types of debt are discharged under Chapter 7. Alimony payments and child support, for example, won't get wiped clean in the process. The same holds true for certain types of tax debt, and if you're hoping Chapter 7 will eliminate those pesky student loans, here's some bad news: Student debt typically isn't dischargeable in bankruptcy, either.
And it won't stop you from making the same mistakes all over again
Though credit counseling is a prerequisite to declaring bankruptcy, many people who take advantage of Chapter 7 wind up back in the same place all over again, and for one simple reason: Bankruptcy doesn't teach you how to manage your finances. Sure, you might file and wipe out some or all of your debt, but what's to stop you from falling into a similar pattern down the line? A better bet is to take a hard look at your spending habits -- either on your own or with the help of a debt counselor, which won't cost nearly as much as a bankruptcy lawyer -- and learn how to make smart money-management decisions going forward.
Before you declare bankruptcy, consider some alternatives that won't affect your credit for such a lengthy period of time. You could try negotiating with your creditors, either on your own or through a debt settlement company. If you owe a creditor $3,000 and haven't managed to pay a dime thus far, then that creditor may be willing to accept a $1,500 settlement and write off the rest. Other creditors might lower your monthly payments and give you more time to repay your debt if that's what it takes to get their money.
Another option is to generate more cash flow to pay down your debt. Try taking on a second job, downsizing your living space, and reducing your monthly expenses. If you manage to snag a part-time gig that gives you an extra $100 per week, in a year you'll have an extra $5,000, which can go a long way toward paying off debt. Similarly, if you can cut your rent by $200 a month, that's another $2,400 a year you can put toward your outstanding bills. Even small changes can go a long way. If you make just two or three moves that reduce your monthly spending by $10 each, over the course of a year, you'll have a few hundred bucks to chip away at that debt pile.
No matter your strategy, taking an active role in getting out of debt is far better than jumping on the bankruptcy bandwagon and resigning yourself to the financial upheaval that will follow.