Bankruptcy is a drastic action but a viable solution for certain types of financial peril. However, misconceptions about bankruptcy abound.
Filing for personal bankruptcy does not always mean that someone cannot resist the temptation of credit cards. Many people will file for bankruptcy for other reasons.
Here’s a look at five myths surrounding consumer bankruptcy.
[Read: Best Secured Credit Cards.]
People Who File for Bankruptcy Are Financially Irresponsible
That’s just one piece of the picture. Many factors can lead someone to file for bankruptcy.
Job loss, divorce or the high cost of medical care have all driven well-intentioned Americans into bankruptcy.
The financial fallout from the coronavirus pandemic has begun to trigger a wave of business and household bankruptcies.
Bankruptcy Discharges All Past Debts
Many people file for bankruptcy, hoping for a fresh start. But several types of debt are not discharged by bankruptcy.
“If you have domestic support obligations (such as alimony or child support), those can’t be removed under any circumstances,” says Lita Epstein, author of “The Complete Idiot’s Guide to Personal Bankruptcy.”
Student loan debts typically can’t be discharged in bankruptcy, unless you can prove a hardship.
Tax debts are sometimes reduced or discharged, depending on the circumstances, such as the age of the debt. But criminal fines and restitution imposed as part of a sentence cannot be discharged in bankruptcy.
If You Spend Recklessly Before Bankruptcy, You Won’t Have to Pay Back That Money
You could end up in trouble if you do this. Maxing out your credit cards in the hopes that your balances will be forgiven through bankruptcy is called presumptive fraud, says Leslie H. Tayne, financial attorney and founder, Tayne Law Group.
What to avoid: spending $725 or more on luxury goods or services within 90 days of filing for bankruptcy or taking a cash advance of $1,000 or more on a single credit card within 70 days of filing.
Bankruptcy Ruins Your Credit Forever
A bankruptcy can stay on your credit report for up to 10 years from your filing date, but its effect on your credit score diminishes over time before it drops off your report.
People who file for bankruptcy are often surprised by how soon their credit score can improve afterward. Epstein says she has seen people qualify for a mortgage within two or three years of a bankruptcy, depending on the circumstances.
Offers for low-limit secured cards, which require a deposit, can arrive within a month of the debt discharge, she says.
When you’re coming out of bankruptcy, get a secured credit card and consistently pay your bill on time to rebuild your credit, Epstein recommends.
“Usually, about six to 12 months into it, you can get a regular credit card and drop the secured credit card since the secured card can be expensive,” she says. “But if you take on a credit card and start making late payments, your credit score will not improve.”
After your debts are discharged, don’t forget to check your credit report for accuracy. You’ll want to make sure the discharged debts are marked appropriately.
Bankruptcy Is a Cure-All
“Bankruptcy is often thought of as the end-all, be-all of getting out of debt, or even the only option when you have debt,” Tayne says, but “it doesn’t always work, and not everyone qualifies.”
If you file for Chapter 7 bankruptcy, she explains, your debt will be wiped out. But if you file for Chapter 13 bankruptcy, you will pay back a portion, if not all, of your debts over three to five years.
“In some cases, if you file a Chapter 13, the trustee could require you to pay back your debts at 100 cents on the dollar, making the bankruptcy costly,” Tayne says.
Indeed, filing for bankruptcy is not cheap. You can expect to pay between $1,500 and $4,000 in court and attorney fees.
You will also be required to complete credit counseling before you can file for bankruptcy.
“Those looking to file for bankruptcy will have to go through several processes to determine their eligibility,” Tayne says.
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Update 10/16/20: This story was originally published on an earlier date and has been updated with new information.