Why Bankruptcy

The bills are piling up. The collection agencies are calling. At night you lie awake, wondering how you're ever going to cope with your debts.

At what point does it make sense to throw in the towel and file for bankruptcy?

There's no one-size-fits-all answer to that question. In purely financial terms, the answer depends on:

• Your current situation.
• Your future prospects.
• The laws in your state.

There is, of course, another factor to be weighed, which is your personal sense of responsibility for repaying the debt you've incurred. We'll get to that in a moment.

For now, let's explore the purely financial and legal aspects of bankruptcy.

A bankruptcy filing halts, at least temporarily, all collection activities, from phone calls demanding payment to more serious actions including foreclosure, wage garnishment and levies against your bank accounts.

What happens next depends on the type of bankruptcy you file:

• In the most common type of filing, Chapter 7, your credit card balances, medical bills and most other unsecured debts are erased entirely. (Certain other unsecured debts, like student loans and recent taxes, typically can't be wiped out in bankruptcy.) Technically, some of your property could be taken and sold to satisfy your creditors; the types of property that could be taken vary by state. In some states, for example, only a small amount of home equity is protected from creditors, while in others like Florida and Texas the amount of equity that can be sheltered in a home is virtually unlimited.
• In Chapter 13 filings, you're allowed to keep property that might otherwise be used to pay your creditors. In return, you agree to a plan to repay at least some of your debts over the next three to five years. If you complete the plan, the remainder of your eligible unsecured debt is legally erased.

Under 2005 federal bankruptcy reform legislation, you may be required to submit to a "means test" if you file for Chapter 7 and your income exceeds the median for your area. If the means test determines you can afford to repay some of your debt, you'll be shunted into a Chapter 13 repayment plan.

Either way, your credit will be devastated for a while. Bankruptcy is the single worst thing you can do to your credit scores, the three-digit numbers lenders use to gauge your creditworthiness. That means, for a time at least, it will be more difficult and expensive for you to get credit.