Your 5-Minute Guide to Bankruptcy

Here are tips for limiting the damage before, during and after your filing.

By MSN Money staff

Overwhelmed by debt? Bankruptcy is the means of last resort to rebuilding your financial well-being.

Before you make the decision to file for bankruptcy, consider the following:

• Can you accept the immediate consequences of bankruptcy: ruined credit, higher interest rates on new loans and credit cards, higher insurance premiums, difficulty renting a new apartment? Chapter 7 remains on your credit reports for seven to 10 years, Chapter 13 for seven.

• Can you avoid bankruptcy by cutting expenses, getting a second job, negotiating with creditors to reduce your interest or payments (see “Make a deal with debt collectors“) or setting up a debt-management plan with an agency affiliated with the National Foundation for Credit Counseling? (See “The consumers’ guide to credit counseling.”)

• Doing nothing about your debt is an option only if you’re happy being a pauper. If you have assets, your creditors can sue you and take them. Judgments against you last for 10 years and can be renewed for two additional 10-year periods. (See “What if you just ignore your debts?“)

• Remember, bankruptcy is not a badge of dishonor. Most people who file got in a hole because of divorce, a job loss or medical bills, not because of flagrant overspending. (See “7 ways to fight off bankruptcy.”) Most people who file have no alternative: Fewer than 5% of those who participate in the credit-counseling session that’s required before they can file have any resources to pay off their debts.

Bankruptcy may be your best option if it will take more than five years to pay off your unsecured debt, such as credit cards and medical bills. (See “When bankruptcy is best.”) Bankruptcy will not relieve you of secured debt — where the creditor holds a lien — like a mortgage or car loans. It also won’t end your obligation for most student loans, child support, alimony or recent taxes.

5 tips for a smoother bankruptcy filing

If you decide that bankruptcy is necessary for your emotional and financial well-being, take these steps:

• Hire a reputable attorney. The 2005 bankruptcy law increased the amount and complexity of paperwork, including a “means test,” needed to file. Beware of bankruptcy mills that charge high fees for botched service. (See “Beware cut-rate bankruptcy advice.”)

• Get credit counseling from an approved agency within 180 days of filing.

• Gather documents. When you meet with the lawyer, you will need pay stubs, deeds, vehicle titles, tax returns and letters from collection agencies, among other paperwork. Your list of creditors must be complete.

• Don’t run up your credit cards. Bankruptcy courts consider that fraud, and you’ll end up having to pay what you owe on the cards.

• Use the American Bankruptcy Institute and the National Association of Consumer Bankruptcy Attorneys as resources.

For most people, there are two types of personal bankruptcy:

• Chapter 7 requires the sale of nonexempt assets to reduce unsecured debt. The remainder of your unsecured debt will be excused. What’s considered exempt varies from state to state. You are allowed to keep your retirement accounts, and most people retain possession of a car and their home if they keep making payments on them.

• If your income exceeds the median for your family size in your state (see U.S. Trustee Program) and the means test says it’s sufficient to make payments on your debt, you will be directed to file Chapter 13 instead. Under Chapter 13, you keep your property and agree to a three- or five-year repayment plan for some of your debt. If you follow the plan, the remainder of your unsecured debt will be eliminated. Chapter 13 is generally the better option if you’ve fallen behind on house payments because the plan allows you to catch up.

After you file, an “automatic stay” stops all collection attempts. The stay is temporary for secured debt, so you need to make payments or face repossession or foreclosure. You’ll attend a creditors meeting (creditors rarely attend), where a trustee will finalize your case. You’ll be required to attend a finance management course.

After you file

Take these steps as soon as possible after you file:

• Start to build your credit score by getting a secured credit card or passport loan. (See “7 steps to take after bankruptcy.”) Don’t exceed 30% of your available credit each month and pay your balance in full. After a year, apply for a regular credit card.

• Order your credit reports from the three credit bureaus. Make sure the reports say your debts have been “discharged in bankruptcy.”

• Obtain an installment loan as a way of rebuilding credit, but be prepared to pay a very high interest rate.

• If you have student loans, try to pay more than the minimum required each month.

• Don’t co-sign for a loan. Ever.

• If you intend to keep your car, sign a reaffirmation agreement with your lender.

• Manage your finances wisely. Multiple bankruptcies are possible but are disastrous to your credit. You can file under Chapter 7 every eight years and Chapter 13 every two years.