Bankruptcy Myths

Here's a look at some of the myths surrounding consumer bankruptcy.

1. People who file for bankruptcy are financially irresponsible. "There's always going to be some kind of abuse, but it's far more likely that people run into very serious personal problems in one of three areas: losing their job, going through a divorce, or suffering a serious illness," says Walter W. Miller Jr., who teaches bankruptcy law at Boston University School of Law.

Long-term unemployment, the legal fees associated with divorce, the cost of running two households following a divorce, or the high cost of medical care have all driven well-intentioned Americans into bankruptcy. As of April 2012, more than 5.2 million Americans had been unemployed for six months or longer, according to the Bureau of Labor Statistics. Meanwhile, a 2011 survey by the Centers for Disease Control and Prevention found that 20 percent of American families had problems paying medical bills in the past year.

2. Bankruptcy discharges all past debts. Many people file bankruptcy hoping they'll be able to start fresh afterwards, but several types of debt are not discharged by bankruptcy. "If you have domestic support obligations [such as alimony or child support], those can't be removed under any circumstances," says Lita Epstein, author of The Complete Idiot's Guide to Personal Bankruptcy.

As a result of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005, student loan debts also fall in that category, although a Congressional bill called the Fairness for Struggling Students Act would allow private student loans to be discharged in bankruptcy court. According to Epstein, student loans can be forgiven if you're able to prove a hardship such as permanent disability, but that process is separate from bankruptcy.

Tax debts are sometimes reduced or discharged depending on the circumstances, but as Epstein says, "if you didn't file tax returns, there's no way you're going to get those tax debts removed."

3. If you spend with abandon right before bankruptcy, you won't have to pay that money back. Michael Greiner, a Warren, Mich.-based bankruptcy lawyer and author of Bankruptcy 101: An Insider's Guide to Filing Bankruptcy by Yourself, Without an Attorney, says some people assume they can charge up their credit cards before filing bankruptcy and then have those debts discharged. "Courts have ruled that that's considered fraud, and debt that's incurred as a result of fraud is not discharged," he explains. "If you charged a bunch of stuff before you filed bankruptcy, you usually can't get away with it. That's a misconception."

4. Bankruptcy permanently ruins your credit. People who file bankruptcy are often surprised by how quickly they'll start getting credit card offers in the mail again. Epstein says offers for secured credit cards (which require a deposit to the bank) with a low limit can arrive within a month of the debt discharge. She recommends that those coming out of bankruptcy get a secured credit card and start making regular, on-time payments to rebuild their credit. "Usually about six to 12 months into it you can get a regular credit card and drop the secured credit card, since the secured card can be expensive," she says. "But if you take on a credit card and start making late payments, your credit score will not improve."

After the debts are discharged, it's also smart to check their credit report and "make sure that everything that was discharged in the bankruptcy is marked on their credit as discharged," Epstein adds. She's seen people qualify for a mortgage within two or three years of a bankruptcy, depending on the circumstances.

5. Bankruptcy is a cure-all. Chapter 7 bankruptcy discharges certain debts, while Chapter 13 may reduce or reorganize debts. However, neither one offers an easy solution. "People sometimes think it's going to solve all their problems, and it doesn't," says Miller. "In Chapter 7, you could lose property. If you go into Chapter 13, you could keep your house but also have to keep making payments and have a very modest lifestyle for at least three to five years."

Filing for bankruptcy isn't cheap, either. According to a study released this month by the National Bureau of Economic Research, the average bankruptcy fees increased from $921 to $1,477 after 2005's BAPCPA was enacted. Before filing, applicants are required to go to credit counseling, during which the counselor may explain other options like negotiating a payment plan with creditors. "Bankruptcy is a major disruption in your life," he says. "If you can work it out with creditors, go that route."