Published September 30, 2009 in SMARTMONEY MAGAZINE by Elizabeth O’Brien (Author Archive)
Linda Frakes, an entrepreneur in Georgia, built a life around her six-figure income. But when her new business collided with the credit crunch, Frakes found herself facing a financial fate she never anticipated. “It’s a far way to fall,” she says. Meet the new face of bankruptcy. This nation’s worst downturn in 70 years pushed more formerly affluent people into bankruptcy than in previous recessions. Overall, personal bankruptcy filings were up 36.5 percent in the first half of 2009 from the same time a year ago, and experts predict the number of filings will keep rising even as the economy recovers.
Leslie Linfield, executive director of the Institute for Financial Literacy, calls it “a middle-class recession”: Last year the institute surveyed likely bankruptcy filers and found 8.1 percent made more than $60,000, up from 6.9 percent in 2007. Experts blame the increase on slumping real estate and job losses, which have cut deeply into professional positions. Claire Ann Resop, a bankruptcy attorney in Madison, Wis., sees a
lot of mortgage brokers and real estate developers: “They made a lot of money, and now they can’t.”
2. “When it comes to bankruptcy, one size doesn’t fit all.”
No type of bankruptcy will eliminate certain kinds of obligations, like child support, alimony and most student loans. But there are differences in the way debt gets handled in personal bankruptcy, often depending on which kind you file for, either Chapter 13 or Chapter 7. And each has pros and cons. Chapter 13 allows those with regular income to repay debts over three to five years. That drags things out a bit, but it stops the foreclosure process, meaning debtors behind on their mortgage can keep their house and catch up on payments over time. Those without regular income must file Chapter 7, which involves no payment plan—all eligible debt, such as credit card balances, gets wiped out. But it’s hardly a free pass. Most debtors find the process pretty traumatic, not to mention severely damaging to their credit score. And Chapter 7 doesn’t stop foreclosure, so banks can still take the homes of debtors behind on a mortgage.
How do you know which form is right for you? Bankruptcy law is complex, and certain provisions vary from state to state, so it’s often best for potential filers to consult an attorney before deciding.
3. “We don’t want your house if we can’t get good money for it.”
A common belief about bankruptcy is that it will leave you with nothing, living out of a cardboard box, says Cathleen Moran, a bankruptcy lawyer in Mountain View, Calif. But that’s not necessarily true, even in Chapter 7 cases. In theory, Chapter 7 involves liquidating most of a debtor’s assets to pay creditors, including the home. But in reality, homeowners who end up filing often don’t have enough equity in their home to benefit creditors, either because they’ve taken out a second mortgage, the home’s value has fallen or both. In such cases, the trustee handling the bankruptcy can decide not to liquidate the home, in which case the debtor gets to keep it.
Also, there’s something called the homestead exemption, which in most circumstances allows you to keep your primary residence if your equity in it is below a certain threshold. It can vary widely from state to state: from $30,000 for a married couple filing Chapter 7 in Illinois, for example, to $75,000 for the same in California. But since Chapter 7 doesn’t stop foreclosure—although it tends to delay it by a few months—those behind on their mortgage often can lose their home regardless.
4. “This could actually improve your credit score down the road.”
Yes, bankruptcy will pummel your credit score, says Barry Paperno, consumer-operations manager for FICO, the company that develops the credit scoring formula used by the three major credit bureaus. Yet bankruptcy can be less damaging in the long run than juggling late payments on credit cards for years in a bid to postpone the inevitable. Bankruptcy stays on your credit report for 10 years, but you can begin repairing it immediately, if gradually.
The fact is, most people go bankrupt with lousy credit. They’ll be able to return to (and maybe surpass) their prebankruptcy FICO score more quickly than the rare debtor with pristine credit who needs to file bankruptcy after, say, a serious illness—which could mean a credit score drop of 100 points or more, Paperno says. Since 35 percent of one’s credit score is based on payment history, the further consumers get from any missed payments, the more their score improves, he says.
How to quicken the recovery? Establish new credit as soon as possible, Paperno says, either through a new credit card or car loan, though bankruptcy filers will have to pay higher interest rates.
5. “Debt-settlement firms may do more harm than good.”
Debt-settlement firms offer to play hardball with creditors and whittle outstanding balances by up to 75 percent. They bill their services as an alternative to bankruptcy, but in many cases they can hurt more than they help. Debt-settlement firms are unregulated, for-profit entities that require regular payments before taking any action on a consumer’s behalf. This business model works squarely against the debtors’ interests, says Walter Benenati, a bankruptcy attorney in Orlando who worked briefly for a debt-settlement firm. “They’re getting fees every month, so they have no incentive to settle [with creditors] as fast as possible,” he says.
In fact, you don’t need a middleman to negotiate with creditors. But, says Mariana Bekker, director of media relations for the United States Organizations for Bankruptcy Alternatives, a debt-settlement trade organization, most debtors don’t have the “time, stamina or desire” to do it themselves. Either way, you’ll owe taxes on any amount saved on your debt. (That’s right: The IRS considers forgiven debt taxable income.)
Debt erased as part of bankruptcy, by contrast, isn’t taxed.
6. “Don’t settle with Mom first or fudge the condo in Boca.”
Many debtors naturally want to pay back friends and family before filing for bankruptcy. Yet that can be a big mistake. Any money repaid to “insiders”—including relatives, friends and acquaintances, or business partners—within a year of bankruptcy is recoverable by the trustee. If the recipient doesn’t voluntarily return it, the trustee has the power to sue. A more serious infraction involves trying to hide assets from the court. So don’t even think about giving your Harley to your brother—or selling it for cheap—to protect it from creditors. Bankruptcy filers must list everything they’ve sold, transferred or given away over the past two years. And nothing can be transferred, given away or sold for less than market value.
There are many ways bankruptcy fudgers get caught. Spurned lovers or creditors often turn them in, says bankruptcy attorney Resop. She also recalls a case in which a lawyer read in the paper that a bankruptcy filer he’d represented a few years back was selling property. Turns out the filer had hidden the house from the court. He lost his bankruptcy discharge, letting creditors come after him again. Liars can also wind up in jail for perjury.
7. “Better save up before you file.”
This spring, Angela Watson realized she was in over her head. The Web entrepreneur from Long Beach, Calif., had incurred more debt than expected launching her business and wanted to explore the possibility of bankruptcy.
Yet once she started pricing lawyers’ services, which averaged about $2,000, Watson realized she couldn’t afford to file Chapter 7. Lawyers suggested she borrow the money from family and friends. “I was so hurt by that,” says Watson, who hasn’t even told some of her loved ones about her situation. She’s hoping to file with the help of a legal-services nonprofit.
Lawyers in Chapter 7 cases generally request payment up front; otherwise, their fees would be discharged during the bankruptcy process along with other debt. (In Chapter 13, lawyers’ fees become part of the payment plan.) These fees range from about $500 to $3,000, depending on the state and the complexity of the case. Bankruptcy court also charges routine fees: $245 to file Chapter 7, plus a $39 administrative fee and a $15 trustee surcharge; $235 to file Chapter 13, plus a $39 administrative fee. Consumers seeking free advice can visit the American Bankruptcy Institute’s online pro bono resource locator at probono.abiworld.org.
8. “Just because your bills stop coming doesn’t mean you shouldn’t pay them.”
Not only does filing for bankruptcy stop collection calls, but most bills stop coming too. That’s because the courts immediately file an injunction that prohibits collection actions against the debtor or his property. But that doesn’t mean debtors are suddenly released from payment obligations for secured possessions they want to keep—that’s legal lingo for anything bought with collateral, like a car or house. During Chapter 7 proceedings, which usually last about four months, you must remember to pay for what you want to keep in the absence of a bill. (In Chapter 13, those bills are folded into the payment plan the court establishes.) Besides the house and car, secured possessions could also include an engagement ring or other jewelry.
Debtors must decide to “reaffirm”—that is, keep and stay current on—any secured debt before all other debts are eliminated in bankruptcy. To do that, in the absence of a bill, contact the party you send payment to. For example, those with Chase auto loans should call the company for logistical (not legal) guidance, says a Chase spokesperson.
9. “Timing is everything.”
When you owe more than you own, it’s time to consult a lawyer, Linfield says. But that doesn’t mean bankruptcy is necessarily the next step, attorneys say. It’s often best to wait until you think the worst is over, says David Leibowitz, a Chicago bankruptcy lawyer, because if you
file prematurely, you’ll likely incur more debt, which won’t be included in the bankruptcy discharge. For example, those facing hospitalization may want to postpone until that’s behind them. And for Chapter 7 filers who stand to lose their home, holding off on filing can maximize the time living in the residence without making mortgage payments. To do this, wait until the eve of foreclosure to file for bankruptcy, Moran says.
On the other hand, there are situations in which it’s best not to wait. Those with no hope of repaying debt often have little to gain by postponing. In such cases, it’s usually better to bite the bullet sooner rather than later.
10. “Bankruptcy doesn’t have to be the end of the world.”
There’s nothing easy about bankruptcy. It can be especially hard for middle-class filers who face a swift and unexpected slide down the socioeconomic ladder. And those who file for medical reasons suffer the double burden of health problems and financial distress. An important part of the coping process, mental-health professionals say, involves acknowledging the normal feelings of depression, fear and anger that often accompany bankruptcy.
But many people emerge from it stronger than they expected. It helps that bankruptcy has become more widespread these days, lessening its stigma. “Misery loves company,” says Richard Shadick, a psychologist and the director of a counseling center at Pace University in New York City. Before she filed, Frakes, the Georgia entrepreneur, dreaded the process and worried about how it would leave her. “I thought I’d be living in a double-wide,” she says. Instead, she parlayed her marketing skills into a deal on a new rental when she lost her home in Chapter 7. (She offered to market the subdivision in exchange for a lower rent.) She lost her old Chevy but got a bargain on a used Jaguar. More rewarding than these material comforts, Frakes says, was that she emerged from bankruptcy with her friends, her family and her faith intact. Indeed, support networks often make all the difference in helping people cope with bankruptcy, counselors say, so don’t be ashamed to reach out.