6 Alternatives to Bankruptcy

Financial emergencies like unexpected medical bills can be difficult for many Americans to cope with. 36 percent of adults report that they would not be able to cover a $400 unexpected expense without borrowing money or selling belongings. And healthcare issues or job loss can leave families with a much higher debt balance that can feel unmanageable. It’s understandable that those overwhelmed by debt would want to wipe the slate clean. But bankruptcy can have a devastating impact on your financial future and should always be considered a last resort. Before you proceed with filing, you should be aware of all the alternatives available to you.

What Is Bankruptcy?

Bankruptcy is a legal process by which an individual can get rid of an excessive amount of debt. There are two types of individual bankruptcies:

• Chapter 7 bankruptcy, in which a bankruptcy trustee liquidates your assets to repay your creditors and releases you from liability for repayment
• Chapter 13 bankruptcy, in which you can keep your assets and enter into a three to five-year repayment plan during which you will live on a fixed budget

Both types of bankruptcy can help stop phone calls from debt collectors, prevent foreclosure or repossession, and eliminate unsecured debt. Each type of bankruptcy has different eligibility requirements and comes with certain benefits and drawbacks. But both are costly, especially if you need help from an attorney. It’s possible to file for bankruptcy yourself, but if your case proves to be complex, you may need legal assistance.

What Are the Consequences of Bankruptcy?

• You’ll lose your property if you file for Chapter 7 bankruptcy. While some assets will be treated as exempt property, such as your primary vehicle up to a certain value, you could lose your home if you’re behind on your mortgage. And while Chapter 13 bankruptcy can help you keep your house and your other assets, you may have difficulty adjusting to your budget with the repayment plan.
• You’ll tank your credit score by up to 240 points, according to FICO. If you have fair credit, or a score of 680, your score will typically drop between 130 and 150 points. But creditworthy borrowers can expect an even greater drop. It can take a long time to rebuild your credit, since a chapter 13 bankruptcy will remain on your credit report for seven years and a chapter 7 bankruptcy will remain on your credit report for 10 years.
• You may not be able to get a loan or a mortgage after you file for bankruptcy. Getting an auto loan or credit card after bankruptcy can prove difficult until you rebuild your credit. You may need to apply for a credit builder loan or secured card to start with. You’ll also have difficulty getting approved for a mortgage with a reasonable interest rate. If you currently own your home, you may want to reaffirm your mortgage during bankruptcy, since it could take a while to become eligible for another home loan once you’ve filed.

6 Alternatives to Bankruptcy

Debt Management Plan

Whether you file for chapter 7 or chapter 13 bankruptcy, you’ll need to start with a credit counseling course from an approved credit counseling agency. Whether you’re considering bankruptcy or not, talking to a credit counselor is a great place to start if you’re overwhelmed with debt. Depending on your individual situation, a credit counselor may recommend reevaluating your budget or consolidating your debt to get back on track, or they may recommend a debt management plan. With a debt management plan, a certified credit counselor negotiates an agreement with your various creditors. Once you’ve signed up, you’ll make a lump sum payment each month to the nonprofit credit counseling agency, which will distribute the funds directly to your creditors. The credit counseling agency can help you achieve a lower interest rate, wipe away fees, and get a lower monthly payment, so you can get out of debt faster with less strain on your budget. While a debt management plan will appear on your credit report, it won’t negatively impact your score. In fact, as you make on-time payments and reduce your debt utilization, you may actually see your score begin to improve. In fact, independent research has shown that participants in credit counseling see an average 50-point improvement in their credit score six quarters after counseling.

Debt Consolidation

If you have several high-interest loans and your credit is still in good shape, you may be able to take out a personal loan with a low interest rate to pay off your other debt. This can help you save money over time, and it can also help you achieve a lower monthly payment, which will put less strain on your budget. If you have equity in your home, you may also be able to use a home equity loan to pay off your other debt. You’ll typically need to have at least 15 percent equity in your home and a fair credit score to be eligible. Most lenders will also require a debt-to-income ratio of 43 percent or less, so if you’re drowning in other debt, this may not be an option.

Debt Transfer

Many credit card issuers offer a 0% introductory APR period for 12 to 18 months. If you choose a card with a low balance transfer fee, you can save money on interest by transferring your debt from another credit card. But this will only work if you also reevaluate your budget and devote enough money to debt repayment to be out of the woods by the time the introductory period ends.

Debt Settlement

The Federal Trade Commission and the Consumer Financial Protection Bureau both strongly caution Americans against signing up with a for-profit debt settlement company. Debt settlement requires that you stop making payments until the debt settlement company reaches an agreement with your creditors to settle your debt for less than you owe. There’s no guarantee you’ll save, and you’ll destroy your credit in the process. You’ll also be required to pay income tax on any forgiven debt, and the for-profit company could charge you high fees. Another risky option is to default on your debt until you can reach settlement agreements with your creditors directly. You’ll likely receive calls from debt collectors, but they won’t sue you if you don’t have any assets to collect. Once you’ve been in default for some time, your creditors may accept a lump sum payment for less than you owe. But you’ll owe income taxes on any forgiven amount and your credit score will drop in the process.

Liquidating Assets

While you may not have cash on-hand to repay your debts while managing your necessary expenses, you could own property or have money in an investment account or retirement account. While selling your house to pay your debt could leave you vulnerable to homelessness, selling a motorcycle or second car would be a manageable sacrifice. And borrowing from a retirement account may be preferable to filing for bankruptcy, depending on your individual situation.

Borrowing from Family and Friends

If you’re considering bankruptcy, you’re probably looking at a high debt balance. It can be difficult to ask for help when you’ve been in trouble for a while, but asking one or more family members for assistance is one of the best ways to tackle your debt without destroying your credit score. You might also utilize crowdfunding if you have a large number of friends who can each contribute a little bit of money towards your debt. This can be successful if you have medical debt or financial problems that arose through no fault of your own.

Identifying Debt Relief Scams

Signing up with a debt settlement company is risky, even if the company is legitimate. They may not be able to settle your debts on your behalf, and you’ll incur many late payments on your credit report in the meantime. But you should be especially cautious of the following red flags, which indicate a fraudulent company:

• The company charges upfront fees for its services
• The company promises to settle all your debt at a given discount
• The company claims that a new government program can provide relief
• The company promises to stop debt collection calls and lawsuits
• The company makes you agree to stop contacting your creditors

Life After Debt

Whether you file for bankruptcy or choose an alternative, you’ll need to rehabilitate your finances. You should identify what caused you to fall into debt in the first place and form new financial habits that help you avoid borrowing in the future.

Use a Budgeting Strategy

Having a strategy such as the envelope budgeting system can give you greater control over your money. Start by adding up your sources of income and subtracting any recurring bills. Then, designate 10 to 15 percent of your income for your retirement savings and another 5 to 10 percent of your income for rebuilding your emergency fund. From there, you can deposit your leftover income among different categories, such as groceries, dining out, and entertainment. The envelope budgeting system is cash-based, but you can achieve similar control with a digital solution like a budgeting app.

Automate Your Savings

Once you’ve determined that your strategy works and you know how much you can save, set up automatic payroll deductions for your retirement account and enroll in automatic monthly deposits into a high-yield savings account. Financial advisors have long offered the advice “Pay yourself first,” which refers to putting money in a savings account before you spend any of your available cash. Automating your savings is a great way to accomplish this.

Rebuild Your Credit

Your payment history and credit utilization are the most important factors influencing your score, so be sure to make your payments on time and keep your debt balances low relative to your credit limit. You may need to make credit card payments throughout the month or request a higher credit limit as your score starts to improve. You should also set up automatic payments to avoid forgetting to pay any of your bills. If your credit has been totally destroyed or you have no credit history, you may need to apply for a credit-builder loan or secured card in order to get back on track. But avoid bad credit loan options like payday loans, which can create an ongoing cycle of debt. If you do need to borrow, choose a lender that reports to the major credit bureaus and can give you a longer-term loan with a lower interest rate.

The Bottom Line

If you’re deep in debt, it might feel like there’s no way out. But you have options besides bankruptcy. Start by consulting a nonprofit credit counselor. It’s possible their advice can help you dig your way out of debt on your own, or you may need help with a debt management plan. If your situation is especially severe or complex, your credit counselor may recommend bankruptcy.