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Is Bankruptcy a Solution to Debt Trap Trouble?

If done properly, bankruptcy protection can go a long way toward rehabilitating your credit score -- and improving your overall financial health.

Monopoly Bankruptcy Cartoon

For people stuck in a serious debt trap, it seems like there is one obvious solution -- bankruptcy. With the stroke of a judge's pen, all debts are dissolved, the trap disappears, and the borrower can move ahead free and unencumbered.

If only it were so easy.

The truth is far more complex. While bankruptcy protection makes sense in some situations, it's not a magic wand solution. It's also not available to everyone, or applicable toward every debt. Additionally, bankruptcy comes in a variety of forms, so identifying the right kind of bankruptcy protection is also a requirement.

With that in mind, let's take a deeper dive into how bankruptcy laws can help you escape a lingering debt trap.

When to Consider Opting for Bankruptcy Protection

While it's true that filing for bankruptcy can protect your assets and help you eliminate or reduce your debts, there are some factors that need to be weighed. First, you should be aware that bankruptcy laws do not extend to all debts. Students loans, for example, cannot be discharged in bankruptcy without a hardship exception -- something for which it's extraordinarily difficult to qualify. So if your debt trap is largely of the student loan variety, bankruptcy proceedings may be of little help.

Second, it's important to note that there are different types of bankruptcy protection, with Chapter 7 and Chapter 13 being the two most common forms for personal filings. Those filing Chapter 13 typically agree to a three-to-five year payment plan to reimburse creditors some or all of what they are owed. At the end of this period, unsecured debts are forgiven. Chapter 7, on the other hand, wipes out unsecured debt almost immediately.

Both forms of bankruptcy can stop foreclosure proceedings. Those opting for Chapter 13 can roll outstanding mortgage payments into their new payment plan, which can put a permanent hold on foreclosure proceedings. Chapter 7 will only stop foreclosure proceedings temporarily, however. 

While Chapter 7 may seem like the better deal as it wipes the slate clean without a repayment plan, the eligibility requirements are stricter. Typically you must earn less than your median state income, or pass a means test, to qualify for Chapter 7. There is no such eligibility floor for Chapter 13. 

Which Form of Bankruptcy Makes Sense for Me?

Your financial status is key to determining the best form of bankruptcy protection for you. If you are unemployed or have relatively few assets, Chapter 7 is the fastest and most effective way to reduce your debts. Homeowners who have an underwater mortgage are also well-suited for Chapter 7, as they have no equity to protect.

Homeowners with significant equity may wish to opt for Chapter 13, however, as they may run the risk of having their home liquidated under Chapter 7. As mentioned above, homeowners facing foreclosure may be better off with Chapter 13 as it offers a permanent path out of foreclosure.

Finally, those with significant assets or a comfortable salary may find themselves ineligible for Chapter 7, depending on state regulations. Borrowers should also be aware that declaring bankruptcy will appear on their credit report for between seven to ten years, and will have an impact on their score. The negative effect diminishes over time, however, and a good credit score can be achieved within three to five years post-bankruptcy.

The Takeaway

Bankruptcy isn't a "get out of debt trap free" card. Yet if done properly, bankruptcy protection can go a long way toward rehabilitating your credit score -- and improving your overall financial health.