Credit card debt can be a significant financial challenge when the weight makes it impossible to keep up with your payments. If you’re suffering from unmanageable credit card debt, you may consider bankruptcy, which can offer a fresh financial start by discharging or reorganizing credit card debt.
Bankruptcy may offer a way out, but it’s a drastic measure and not a decision to take lightly. Understand the process, potential consequences and alternatives when considering whether bankruptcy is right for you.
[Read: Best Balance Transfer Cards]
How Credit Card Debt Can Lead to Bankruptcy
Credit card debt is a growing financial burden for millions of Americans. U.S. consumers hold $1.17 trillion in credit card balances, according to the New York Federal Reserve Bank’s November Household Debt and Credit Report. Those balances can be unsustainable for some cardholders, with an average credit card balance of $6,000 for households with credit card debt.
Meanwhile, credit card interest rates are some of the highest collected, coming in at close to 21.5%, according to the Federal Reserve. High interest rates can compound the problem of carrying credit card balances, and some cardholders may struggle to keep up. If you miss credit card payments, you’ll pay late fees and penalty interest rates, exacerbating the mounting debt cycle.
When credit card debt becomes unmanageable, it can feel difficult or impossible to get out. Fees and interest charges add up every month, and you may not be approved for a balance transfer card or debt consolidation loan if your credit rating is poor due to high balances and missed payments. Bankruptcy may be an option for legally discharging or reorganizing credit card debt if you can’t dig your way out through less drastic means.
Types of Bankruptcy
There are two major types of consumer bankruptcy: Chapter 7 and Chapter 13. Chapter 7, known as liquidation bankruptcy, is designed to quickly discharge unsecured debts such as credit card balances. You’ll have to pass a means test to file Chapter 7 bankruptcy, which compares your income with expenses to determine whether you can pay your debts. If you have enough to make payments, you won’t qualify. You’re also ineligible if you’ve filed for Chapter 7 within the past eight years.
“The means test is basically a way for the court to consider your income to determine if there is a good faith reason why you are in Chapter 7 and can qualify to cancel your debt,” says Virginia attorney Ashley F. Morgan.
Chapter 13, known as payment plan bankruptcy, allows debtors to keep their property while restructuring debts into a court-approved payment plan. A bankruptcy lawyer can help determine which type of bankruptcy is appropriate for you, but it’s good to know the key factors if you’re considering either option.
— Chapter 7: This option wipes out credit card debt without repayment. You must pass a means test, and some assets must be surrendered in Chapter 7, though assets including your home, retirement accounts and main vehicle may be exempt depending on the state where you file bankruptcy.
— Chapter 13: You may choose Chapter 13 if your income is too high to pass the means test or you’re concerned about losing assets. A Chapter 13 bankruptcy sets up a three- to five-year payment plan based on your disposable income, unprotected assets and tax debt.
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Chapter 7 and Chapter 13 handle credit card debt differently. “With Chapter 7, credit card debt is completely wiped out in just a few months,” Morgan says. “It is a quick and efficient process, but there’s a chance you might lose nonexempt assets if their value exceeds the legal limits.”
However, Morgan warns that Chapter 7 can be difficult because exemptions vary substantially from state to state. “A Chapter 13, on the other hand, lets you keep your property but requires you to pay back part of your credit card debt over three to five years,” says Morgan. “It’s a great option if you have valuable assets or need time to catch up on payments for things like your home or car.”
One major benefit of Chapter 13, says Morgan, is that balances are frozen as of the day of filing — and you don’t have to pay additional interest during the payment plan.
Chapters 7 and 13 are the most common bankruptcy chapters for individuals, but other chapters address unique circumstances. For example, Chapter 12 is specific to farmers and fishermen.
Special Considerations for Credit Card Debt in Bankruptcy
Bankruptcy can discharge or restructure most credit card debt, but there are exceptions. For example, luxury purchases or cash advances made shortly before filing may be nondischargeable. Additionally, debts incurred by intentional misrepresentation or fraud are excluded from discharge.
Credit card debt that paid for nondischargeable obligations such as taxes or child support may not be discharged. Sole proprietorship business credit card debt may be dischargeable, but corporate card debt may require additional consideration.
[Read: Best Personal Loans.]
Drawbacks and Consequences of Filing for Bankruptcy
Filing for bankruptcy isn’t a decision to take lightly, as it has short- and long-term consequences and can be financially and emotionally disruptive. Your credit score may fall after filing bankruptcy, and the legal process can be intrusive as a court-appointed trustee reviews your financial records. Bankruptcy filings remain on your credit report for up to 10 years for Chapter 7 and seven years for Chapter 13, making it challenging to get loans, credit cards and housing.
People who file for bankruptcy may feel shame, and dealing with financial struggles can take an emotional toll. You’ll also face costs for filing fees, legal representation and potential asset liquidation.
However, the benefits of handling credit card debt with bankruptcy may outweigh the drawbacks — which might not be as bad as you imagine. “Most people expect their credit score to plummet after bankruptcy, but that’s not necessarily true,” says Jay Fleischman, managing attorney of MoneyWise Law. “If you had bad credit when you filed, the damage was likely already done.”
Your credit score might bounce back relatively quickly after filing bankruptcy, says Morgan. “With responsible financial habits, many people rebuild their credit within two years,” she says. “For instance, you can qualify for an FHA mortgage two years after Chapter 7 or a car loan immediately, though waiting six months to a year can help secure better interest rates.”
[Read: Best Debt Consolidation Loans.]
Alternatives to Bankruptcy for Credit Card Debt
While bankruptcy can provide a clear path out of credit card debt, it’s a drastic measure and generally not recommended until you’ve tried other options first. Consider these steps before you file for bankruptcy over credit card debt:
— Lifestyle adjustments: Creating a realistic budget and reducing expenses can free up funds to effectively pay down debt. However, this can fall short if you have overwhelming debt or insufficient income relative to your expenses.
— Credit counseling and debt management: Credit counseling agencies can create debt management plans to consolidate your debts into a single payment and may negotiate lower interest rates with creditors.
— Debt settlement: Debt settlement negotiates with your creditors to reduce the amount you owe. You’ll typically make lump-sum settlements or pay in installments. However, debt settlement scams are prevalent, and forgiven debt may be considered taxable income.
“The impact of filing for bankruptcy varies based on your individual situation,” says Fleischman. “Filing will allow some people to rebuild a solid financial foundation immediately without negatively impacting their lives. Others may risk the loss of assets that can’t be protected under Chapter 7, so they should consider Chapter 13.”
If you’re suffering from credit card debt, he recommends meeting with an experienced bankruptcy lawyer to discuss the pros and cons of filing for bankruptcy.
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Can I Declare Bankruptcy for Credit Card Debt? originally appeared on usnews.com