When debt overwhelms your finances, you may consider filing for bankruptcy. This legal process controls and eliminates debt through the courts according to your ability to pay. While it eases your financial stress, it can devastate your credit for up to a decade. Because of these risks, you should consider all alternatives before you file for bankruptcy. Learn how to avoid bankruptcy, which type of bankruptcy is best for your situation and other options to pay off your debts.

What is bankruptcy?

Bankruptcy is a legal process to eliminate and repay debt through a court-ordered schedule. When you file bankruptcy, the court issues an automatic stay, which means that all creditor collection efforts and wage garnishments cease must stop. During bankruptcy, you may “reaffirm” any types of debt that you want to keep, such as a mortgage or car loan. There are multiple types of bankruptcy, depending on who you are, how much you owe and your ability to repay.

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Filing bankruptcy immediately impacts your credit score. On average, bankruptcy reduces credit scores by 130 to 200 points. While bankruptcy stays on your credit for up to ten years, the impact to your score lessens over time. Using credit responsibly builds a solid foundation for rebuilding your credit after bankruptcy.

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There are numerous signs that you may be headed toward bankruptcy. If you’re having trouble making the minimum payments on your debt or are using credit cards to pay for essentials, you may be under financial distress. As your situation deteriorates, creditors may attempt to recover their money by making collection calls or filing a lawsuit in court.

Types of bankruptcy

When you hear the term bankruptcy, many people assume that it’s all the same. In fact, there are multiple options available within the bankruptcy code. The type of bankruptcy you'll file depends on who you are, how much you owe and your ability to repay your debts.

Chapter 7

Chapter 7 bankruptcy is known as a “fresh start” because it wipes away most debts. This type of bankruptcy is available for both consumers and businesses. Consumers use Chapter 7 to eliminate unsecured debt, like credit cards, unpaid taxes and payday loans. Businesses file Chapter 7 when they are going out of business

Chapter 13

A Chapter 13 bankruptcy creates repayment plans where people or small businesses repay a portion of their debts over a three to five year period. They work with their attorney and a Chapter 13 Bankruptcy Trustee to determine how much disposable income they have based on reasonable monthly expenses. Over the next three to five years, they’ll make monthly payments to the Trustee, who then distributes the money to creditors proportionately. With Chapter 13, debtors can have up to $2.75 million combined of secured and unsecured debt.

Chapter 11

Chapter 11 bankruptcy is a more complex version of Chapter 13. It handles bankruptcies for consumers and businesses with higher levels of debt or those wanting a longer repayment period. Generally, a Chapter 11 filing is more expensive than Chapters 7 and 13 and takes longer to proceed through bankruptcy court.

Uncommon types of bankruptcy

In addition to the three main types of bankruptcy, other versions cover unique situations. Local government entities (aka municipalities) file Chapter 9 to reorganize their debts. Chapter 12 bankruptcy allows family farmers and fishermen to create a repayment plan through the courts. When the bankruptcy involves more than one country, the company may file under Chapter 15.

How to avoid bankruptcy

You can avoid bankruptcy by adopting good financial habits, increasing your income and resisting unnecessary spending. Adopt these simple financial habits to improve your finances and avoid having to file for bankruptcy.

Create a budget and stick to it

Being proactive with how you spend your money allows you to take control of your finances. While many people view budgets as restrictive, they actually reduce stress and create freedom. Budgets assign your income to different categories based on your monthly bills, saving goals and spending habits. Sticking with your budget helps you control spending and make progress toward your financial goals.

Build an emergency fund

An emergency fund is a dedicated savings account that you can tap in case of unexpected bills. Ideally, you’ll have three to six months of expenses saved up in case of job loss, injury, illness or other emergency. Most people don’t have this much set aside currently, but you can start building your account with regular contributions each paycheck.

Pay down debt

Reducing your debt provides greater flexibility each month with your paycheck. By paying down your debt, you’ll reduce interest charges on your debts. Additionally, once your debts are paid off, you’ll have extra money that can be used to meet your other goals, like retirement, college tuition or a new home.

Avoid high-interest loans and credit cards

High interest rate debt makes it harder to achieve your money goals because so much of your monthly payment goes toward interest charges. Paying down these balances quickly can minimize the interest you’ll pay and free up extra money every month. If you use credit cards for monthly expenses, only charge what you know you can pay off in full each month to avoid interest.

Seek help from a financial advisor

A financial advisor has education and experience with people from a variety of financial backgrounds. Their expertise can help you answer questions and create a plan to avoid money problems. Services include setting up a budget, setting up retirement accounts, buying life insurance and creating an estate plan.

What to do if you're considering bankruptcy

If you're considering bankruptcy, these steps will minimize stress and help the process go more smoothly.

Speak with a credit counselor

Credit counselors provide advice to consumers having trouble paying their debts. While bankruptcy remains an option, they’ll explore alternative courses of action that may be less impactful to your credit. Counselors can review your finances, negotiate with creditors and establish payment plans to get you out of debt. In some cases, they can get creditors to waive fees and reduce interest rates.

Seek advice from a bankruptcy attorney

Many attorneys offer free in-person or phone consultations with consumers considering filing for bankruptcy. During this meeting, they’ll review your income, expenses and debts to determine if bankruptcy is a good option for you. If so, they’ll share which type of bankruptcy you should file, what the process is and how much the fees are.

Gather all of your information

Before meeting with a credit counselor or attorney, gather all of your financial information to make the meeting as productive as possible. Print out copies of your most recent tax returns, paycheck stubs and monthly bills. Also, bring the most recent loan statements for all debts and a copy of your credit report. All consumers can get one free copy of their credit report each year from each credit bureau at AnnualCreditReport.com.