4 Bankruptcy Myths -- Debunked

By Markets Fool.com

Sometimes, even the most fiscally responsible people wind up in situations where they're unable to pay their bills. In fact, the single greatest cause of bankruptcy among U.S. filers isn't reckless spending, but rather medical debt. If you've reached the point where you're unable to keep up with your bills, Chapter 7 bankruptcy may be an option for you to consider.

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Chapter 7 offers filers a chance to liquidate their assets, eliminate much of their debt, and start over with a clean slate. However, there's also a lot of mystery surrounding Chapter 7, and it's certainly not a decision to be taken lightly. Let's debunk a few common bankruptcy myths you may have heard.

Image source: Getty Images.

1. You'll lose everything if you file

In a Chapter 7 liquidation, a trustee is appointed to cancel your debts and use your existing assets to repay creditors to the greatest extent possible. It's therefore natural to assume that if you declare bankruptcy, you'll lose everything you own, including your home. In reality, certain assets are exempt in bankruptcy, and there's a good chance you won't lose your home in particular.

If you don't have any equity in your home, for example, that fact can work in your favor. The purpose of selling off your assets in bankruptcy is to generate money to pay back your creditors. If your mortgage balance exceeds your home's value and your home has no equity, then selling it won't do a thing to bring in any money, as all proceeds from the sale would go straight to your mortgage lender.

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Even if you do have equity in your home, there's a good chance that equity is protected by homestead exemptions. On top of federal exemptions, most states have a homestead exemption that will help homeowners hang on to their property in bankruptcy. If you declare bankruptcy in Nevada, for example, the homestead exemption protects up to $550,000 of equity in your home.

2. You'll never get a loan again

Though a Chapter 7 bankruptcy filing will remain on your credit report for 10 years, that doesn't mean you'll automatically be denied a loan every time you apply during that period. According to a study by the Federal Reserve, 90% of people are granted some form of credit within 18 months of declaring bankruptcy. If you take steps to rebuild your credit, you may get approved for a credit card, auto loan, or even a mortgage sooner than you think. There is a catch, though, and it's that you'll probably wind up with a much higher interest rate than someone with a stronger credit history. For this reason, it's best to keep your borrowing to a minimum in the years following a bankruptcy filing.

3. It will eliminate all of your debt

If you think bankruptcy is your one-way ticket to total debt elimination, think again. There are several types of debt that are not dischargeable under Chapter 7. These include alimony payments, child support, and certain types of tax debt. Furthermore, if you're carrying post-college debt, you should know that student loans are rarely dischargeable in bankruptcy.

4. It'll solve all of your financial problems

While the idea of bankruptcy is to help you start over with a clean slate, the truth is that many people who file for bankruptcy wind up in the same position all over again. If you really want to reach a point where you're financially secure, you may need to change your attitude about spending and make lifestyle changes that allow you to focus on saving.

You can start by weighing your current income against your current expenses and seeing how those numbers look side by side. If you're spending more than you're bringing home, it's a sure sign that you're headed down that same unfortunate path. Remember: Lots of people wind up in bad financial situations because they're hit with unforeseen expenses and don't have any savings to fall back on. If you're serious about becoming financially secure, then you need enough wiggle room in your budget to accumulate some emergency savings. If your current circumstances don't allow you to save, you have two choices: start spending less or get a second job to generate more income.

While declaring bankruptcy can be a good way out of a bad financial situation, it isn't for everyone. There are a number of drawbacks to filing for bankruptcy protection, so it pays to discuss your circumstances with a trusted credit counselor or attorney and see what makes the most sense for you.

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