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Bankruptcy Basics

Anyone who has considered filing for bankruptcy will tell you it's not easy to find someone to talk to about it. After all, the subject isn't exactly something you'd bring up while standing around the office water cooler. Even if you know someone who has filed, broaching the topic can be rather delicate.

At the same time, declaring bankruptcy is a complicated maneuver that must be carefully considered. In other words, it's exactly the type of thing that should be frankly discussed. That's why it's always a good idea to work with both a bankruptcy lawyer and a financial adviser before and after you file.

In the meantime, we can help. Here are answers to the 10 most frequently asked questions about bankruptcy.

  1. I've Heard There's a New Law That Will Make Filing Bankruptcy More Difficult. Is That True?
  2. What's the Difference Between Chapter 7 and Chapter 13?
  3. Is Chapter 7 Bankruptcy Right for Me?
  4. When Does Chapter 13 Make Sense?
  5. Can I Choose the Type of Bankruptcy I File?
  6. Under Chapter 7, Are There Any Restrictions on the Kind of Debts That Can Be Discharged?
  7. Can I Choose Not to Discharge Certain Debts in Chapter 7?
  8. What Happens to My Credit After Bankruptcy?
  9. How Do I Rebuild My Credit?
  10. How Soon Can I Consider Larger Loans, Like a Mortgage?

1. I've Heard There's a New Law That Will Make Filing Bankruptcy More Difficult. Is That True?

Yes. It is called the Bankruptcy Abuse Prevention and Consumer Protection Act and President Bush signed it in April 2005. The key to the new legislation is the so-called "means test," which will determine whether potential Chapter 7 filers could afford to pay back their creditors under a Chapter 13 schedule. The problem is, the test will disqualify from Chapter 7 filing anyone whose income is higher than the median for the state (as determined by the IRS and Bureau of Labor Statistics) and who can afford to pay at least $6,000 or 25% of their unsecured debt (whichever is greater) over five years. This will affect many middle-income individuals or families who earn above their state's median, but are forced into bankruptcy after accruing large debts, often because of divorce or medical emergencies. For details on the new bankruptcy rules, see our story.

The new law, which had been pushed for eight years by banks and credit card companies and was fiercely opposed by consumer advocates and bankruptcy attorneys, will go into effect in October 2005. Until then, the old rules — explained in the answers below — apply.

2. What's the Difference Between Chapter 7 and Chapter 13 Bankruptcy?

If you file for Chapter 7 bankruptcy, most of your unsecured debts are written off within 90 days of filing. The bankruptcy will then stay on your credit report for 10 years. While debts will be forgiven, you will also have to give up some of your property, which will be sold, the proceeds of which will be distributed among your creditors. In most cases, this means you may lose your house (if you own it), as well as any expensive items such as art and jewelry, and pricey consumer electronics.

Chapter 13, on the other hand, is a repayment plan: You set up a three- or five-year schedule with your creditors. Chapter 13 bankruptcy remains on your credit report for seven years. With this type of bankruptcy, you get to keep all of your property, including your home, but need to show that your income will be enough to live on while you're still paying down debts.

3. Is Chapter 7 Bankruptcy Right for Me?

You may be a candidate for Chapter 7 if after you pay for your basic monthly expenses you have no money left to pay off debts. Chapter 7 essentially wipes the slate clean, but you'd most likely lose any valuable possessions.

Just how much a filer will have to hand over depends on where he or she lives. In Florida and Texas, for example, filers can keep their home no matter how much it's worth, but most other states allow only a limited amount of home equity or other property to be exempt. New York, for example, has a $10,000 homestead exemption, explains Jay Fleischman, a bankruptcy attorney with Fleischman Law in New York.

The exemptions for other assets, such as bank and retirement savings accounts and property like furniture and clothes, also vary widely. (Note that 401(k) accounts and Social Security income are federally exempt in bankruptcy, but IRA exemptions vary by state.) But according to Fleischman, no one is in danger of losing personal stuff that may be hard to sell, like an old couch or TV, or even a computer that's a few years old.

Bankruptcyaction.com, a bankruptcy information Web site, has a detailed list of exemptions by state.

4. When Does Chapter 13 Make Sense?

Chapter 13 is typically recommended for debtors who've fallen behind on their payments because of a temporary problem (such as a job loss), but can get back on track if given more time to catch up, explains Fleischman. After filing Chapter 13, a repayment schedule is established that eliminates all interest payments as part of the deal.

5. Can I Choose the Type of Bankruptcy I File?

Sorry. This is a group decision. Obviously, creditors want to get as much of their money back as possible. So even if a debtor wants to file Chapter 13 (say, because he wants to keep his home), he still must pass the ominously named "best interest of the creditors test." This entails proving to the bankruptcy court that under a proposed repayment plan, the creditors would receive more money over time than if they seized the debtor's property (minus the state-allowed exemptions) under a Chapter 7 plan. In other words, the creditors need to know that they'll do better by waiting, says Fleischman.

6. Under Chapter 7, Are There Any Restrictions on the Kind of Debts That Can Be Discharged?

Yes. Child-support and alimony payments, for example, are never dischargeable. Neither are past tax bills, even if paid by credit card. Student loans can be forgiven in very rare situations. "It is possible to do it only if you can prove tremendous health problems that prevent you from working," says Robert Meyer, a bankruptcy attorney in Miami. "It's a threshold most people cannot pass." He says that in his 20 years of practicing law, he has had only one discharge of student loans — for a client diagnosed with a heart condition and a life expectancy of three to five years.

Creditors also have the right to object to the discharge of certain unsecured debts, such as large purchases or cash advances made within 60 days of filing. Those may be any expenses related to travel, vacation, entertainment and things like designer clothes and accessories or anything else that costs more than $1,150. "If you charge up your card on your way to the bankruptcy lawyer, you may have trouble discharging that debt," says Fleischman.

7. Can I Choose Not to Discharge Certain Debts in Chapter 7, Like a Car Loan or Mortgage?

That depends on how much equity you already have in those properties. Theoretically, you can keep a debt obligation after bankruptcy by signing a reaffirmation agreement with your creditor. With such an agreement, you're basically stating that you'll continue to make payments on the debt, even after all your other debts are written off. So, for example, if a Chapter 7 filer wanted to keep a car, he would sign a reaffirmation agreement with his auto lender and continue to make the car payments during and after his bankruptcy.

But here's the catch: If you have more equity in your car or house than your state allows you to exempt from creditors, then even if you reaffirmed the debt, that excess equity would still have to be divvied up between your creditors. Say you have $100,000 in equity in your home and your state has a $10,000 homestead exemption. The $90,000 that's left would still have to go to your other creditors, whether you reaffirm your mortgage or not. In situations like that, says Fleischman, reaffirmation won't do you any good at all.

8. What Happens to My Credit After Bankruptcy?

The most obvious thing that happens when you file for bankruptcy is that you get a notation on your credit report. Your credit score, which is the number creditors use evaluate your credit-worthiness, will also take a hit. Just how badly it will suffer depends in part on how high it was before you filed (scores can range from 300 to 850; the higher the number the better) and how many accounts you're including in the bankruptcy, explains Craig Watts, consumer-affairs manager at Fair Isaac, a company that calculates scores. (You can order your credit score from Fair Isaac. Once you purchase it, you can simulate what will happen to it if you file bankruptcy with Fair Isaac's credit-score simulator.)

Gerri Detweiler, author of "The Ultimate Credit Handbook" and a leading expert on credit, says she has seen scores fall to the low 500- or even 400-point range, too low for a person to obtain new credit. (The average score is 725; but 720 is good enough to qualify for the best rates.) But it won't stay that way forever. "While bankruptcy is very negative, it doesn't mean you can't build good credit again."

9. How Do I Rebuild My Credit?

After filing bankruptcy, many folks are afraid to take on new credit. After all, it was credit that got them in trouble in the first place.

But not doing so can hurt you further down the line, particularly if you plan to take out a car loan or mortgage eventually, says Detweiler. With the following credit-rebuilding plan, you could see your score shoot above 600 in six months.

First, you need to make sure all of your accounts are listed in your credit reports as charged off or included in bankruptcy. For Chapter 7, they should also show zero balances. These accounts will remain on your reports for seven years, but you may call your creditors and ask them to stop reporting them to the bureaus. They don't have to do it, but it doesn't hurt to try. If you were able to remove even a couple of charge-off accounts from your record, that would boost your credit score, Detweiler says.

Next task: Get new credit cards. (If this was part of your financial downfall previously, just keep the credit line low and the cards out of your wallet.) Credit-card companies won't be clamoring to extend you new credit once they see the bankruptcy note on your record, but you could get a secured credit card, which is basically a regular credit card backed by a security deposit you leave with the card issuer for as long as you have the account. Your credit limit will be equal to the amount of your deposit, which will be returned to you in full when you close the account or "graduate" to a regular, unsecured card, explains Detweiler. One thing to keep in mind is that secured credit cards usually carry an annual fee and higher interest rates.

Another fast (and perfectly legal) credit-rebuilding strategy is "piggy-backing" on someone else's credit by asking a friend or relative to add you as an authorized user on one or more credit-card accounts. You won't be responsible for the bills, and you won't have access to the credit cards unless the original owner wants a copy to be sent to you, says Detweiler. The primary cardholder's credit record won't be affected in any way by your bankruptcy. You, on the other hand, "get a benefit of their credit history right away," she says. The potential drawback here is that your own credit could be damaged if your credit-benefactor gets into financial trouble.

10. How Soon Can I Consider Larger Loans, Like a Mortgage or Car Loan?

The good news is, you don't have to wait for the bankruptcy notation on your record to expire before you apply for a mortgage or car loan. These days, you can get a mortgage within a year after bankruptcy, says mortgage expert Brian Saks, author of "Yes, You Can Get a Mortgage," a book on mortgage lending for bankruptcy filers. Most mortgage lenders want to see about a year of on-time payments on various accounts, which may include things like utility bills.

What interest rates can you expect? Well, you won't be able to take advantage of the current record-low mortgage rates, but if you show that you're managing credit well after filing, your lender would probably offer you 8% or less for a 30-year fixed mortgage, says Saks. "The underwriter will want to know why the bankruptcy happened and why it won't happen again," he says. "If you give a good explanation, you may be looking at a rate in the 6% range."

The same applies to car loans. If your credit score is less than 640, you may be looking at rates starting at 10%. But once you show a history of on-time payments after bankruptcy, you're likely to get a more competitive rate.

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