Although walking away from your debt completely may seem tempting, it will have a huge impact on your future financial life. Filing for bankruptcy is generally the more responsible — and safer — option.
If you’re struggling to pay off your debts, you may wonder whether to file for bankruptcy or default on your loans or credit cards.
When you default on your debt, you “walk away” from what you owe, but this will have severe negative financial consequences on your life. On the other hand, filing for bankruptcy can be a complicated and sometimes expensive legal process. However, it may be a good way to start fresh financially, even though it also has some long-term consequences.
In many cases, whether to file for bankruptcy or default on your loans isn’t an either-or question. Many people file for bankruptcy after defaulting on unpaid loans to help protect their assets.
What does it mean to default on your debt?
When you default on a loan or credit card account, you stop making regular payments. Typically, it takes several months of nonpayment for the debtor to consider you in default. The exact number of missed payments depends on the lender and the type of loan.
The advantages of defaulting on debt
Default has no advantages, as it will hurt your finances and credit score for a long time. Not paying can cause late fees, collections actions and even lawsuits.
In rare cases, it may be appropriate to default on a loan as the first step in managing your debt. Some attorneys may even recommend that you stop making your payments before filing for bankruptcy.
Many debt settlement services also require you to stop making monthly payments and instead contribute funds to an escrow account that will be used to negotiate a lower payoff amount. However, note that debt settlement is risky, and some experts even say it’s worse than bankruptcy because of its long-term consequences.
The consequences of defaulting on debt
There are many downsides to defaulting:
- The creditor may impose penalties: If you previously set up a monthly payment plan, the lender will likely cancel it and require immediate payment of the entire remaining balance. You may also lose your current interest rate and have to pay a higher penalty rate and additional fees.
- The creditor may send or sell your debt to a collection agency: This agency may use strong-arm tactics, such as repeatedly calling you to get you to pay the owed amount. Your credit report will note an account in collections and remain there for up to seven years. During this time, it could be harder to get another loan, order new utility services or receive favorable interest rates.
- The creditor may repossess your property: Secured loans are backed by collateral such as a car or house. In the event of default, your creditor may seize the property in order to recoup its losses.
- The creditor may “charge off” your account: In some instances, the creditor may give up on collecting the owed amount and write off the debt as a loss. Typically, this only happens after 180 days or more of nonpayment. However, any charge-offs will appear on your credit report for up to seven years and may damage your credit score.
- The creditor may sue you: Another daunting result of defaulting on your loan could be a future lawsuit. A lender may try to sue you in court to garnish your wages or even put a lien on your house to collect some of the profits when you sell the home.
What happens when you file for bankruptcy?
Filing for bankruptcy after default can prevent lenders or creditors from seizing your assets. The process depends on the type of bankruptcy you file.
Chapter 7
In a Chapter 7 bankruptcy, the court will decide which of your assets to sell to repay your creditors. Most remaining debts will be discharged, except for student loans, child support, some taxes and alimony. The bankruptcy will then stay on your credit report for 10 years.
“When you file for Chapter 7 bankruptcy, it’s known as a fresh start. You can discharge all your unsecured debts so that you’re no longer liable for them,” says Katie Ross, executive vice president of the nonprofit American Consumer Credit Counseling.
The court will appoint a trustee who may liquidate or sell some of your possessions to pay your creditors. While most of your debt will be canceled, Ross says you might choose to pay some creditors to keep a car or home on which the creditor has a lien.
Chapter 13
A Chapter 13 bankruptcy allows you to keep more of your assets while working to discharge some of your debts. Any debts not discharged will be put on a three- to five-year repayment plan. Chapter 13 bankruptcy remains on your credit report for seven years.
“Chapter 13 is about reorganizing financial affairs,” says Michael Sullivan, personal financial consultant with the nonprofit debt counseling company Take Charge America. “A consumer filing for Chapter 13 will have to live on a very strict budget to maximize the payment plan payout to creditors. It works a lot like a debt management plan where there’s a single payment made to a trustee.”
The advantages of filing for bankruptcy
Contrary to popular opinion, filing for bankruptcy isn’t a financial death sentence. If you’re overburdened with debt, a bankruptcy filing may help you wipe the slate clean. Here are some of the advantages of filing for bankruptcy.
It provides you with a fresh start
After filing for bankruptcy, you may be able to rebuild your credit and establish better money habits. As part of the bankruptcy process, you’ll be required to attend credit counseling sessions to learn better ways of managing your money. While you’ll have the bankruptcy on your credit score for several years, the chance to start over and rebuild credit in other aspects may be well worth it.
You’ll get an automatic stay
When you file for bankruptcy, the court will grant you an automatic stay. This means that creditors and debt collection agencies can no longer take action against you until the bankruptcy court discharges your debts or you set up a payment plan.
You may get to keep your assets
If you file for Chapter 13 bankruptcy, you may be able to keep assets, such as your house, vehicles, boats and valuables, which the creditor may otherwise claim for repayment. In Chapter 7 bankruptcy, federal and state law may also prevent some of your assets from being seized.
You may settle your debts for less than you owe
Once you’ve filed for bankruptcy, your creditors must accept whatever amount the court determines you owe. This may mean that you ultimately repay less than the original amount. If you file for Chapter 7 bankruptcy, all your unsecured debts, such as credit cards and personal loans, may be completely written off.
The disadvantages of filing for bankruptcy
Despite the upsides, there are serious drawbacks to a bankruptcy filing.
It can be expensive
When you file for bankruptcy, you’ll need to pay filing and other court fees. You may also need to hire an attorney, as having legal representation can prevent you from making costly mistakes.
It may not clear all of your debts
While bankruptcy can lead to discharge, the process can’t clear all of your financial obligations. This includes any alimony payments, unpaid taxes or court-ordered fines that you owe.
It will affect your credit score and report
Bankruptcy can immediately decrease your credit score, and it remains on your report for seven to 10 years. This may affect your ability to qualify for loans, employment and even rental agreements for much of that time.
Some jobs disqualify people with bankruptcies
Certain jobs require candidates to disclose if they’ve ever filed for bankruptcy, and some companies do a background check that would reveal any bankruptcies. Jobs affected by these restrictions may include positions involving finances, law enforcement, government or high-security positions.
Which options is right for you?
Ultimately, the decision about whether to walk away from your debt or to file for bankruptcy is a personal one. However, it’s generally not recommended to default without a plan to negotiate the debt or declare bankruptcy.
If you feel like you’re unable to pay the debt that you owe, it’s a good idea to contact your lenders first and find out if they will work with you to negotiate a new payment plan or settle for a lower amount. You may find a debt settlement service helpful in this process.
You can also consider contacting a credit counseling agency that will make recommendations on paying off your debt and staying debt-free. A reputable credit counselor may even create a debt repayment plan for you for a small fee.
Alternatives for dealing with debt
Bankruptcy and defaulting on a loan should not be your first strategies if you’re dealing with debt. Before you go to those extremes, see if another option for getting out of debt will work for you.
Debt consolidation
Debt consolidation is when you put your debt into another form, ideally for better interest rates or more favorable payment terms.
A debt consolidation loan is a personal loan you use to pay off other debt, usually from credit cards. Debt consolidation loans typically have low fixed interest rates and terms lasting between one and seven years. Because debt consolidation loans typically have lower interest rates than credit cards, they are a cheaper way to repay high-interest credit card balances.
If you have credit card debt on a card with a high APR, try transferring the balance to a card that offers 0 percent interest APR. This lets you pay down the balance without being charged any interest.
Student loan hardship options
Borrowers with federal student loans can pursue deferment or forbearance for up to three years total. Depending on the type of student loans you have and the type of relief you choose, interest may still accrue during this time.
Another option for federal borrowers is to switch to an income-driven repayment plan with a loan forgiveness option. This will extend your repayment timeline, but because the plan bases your student loan payments on your income, your monthly payment may be as low as $0.
Credit card hardship programs
If you’ve experienced hardship like a job loss, you may be eligible for a hardship program through your credit card company.
The bottom line
Defaulting on your loans and credit cards may lead your creditors to write off the amount you owe as a loss. However, a default may also have negative consequences on your financial life. Your credit score will likely plummet, and your creditors may still sue you for the owed amount.
While bankruptcy can harm your credit score, it could help you reset your financial life. Before taking any dramatic steps to deal with debt, it’s always a good idea to consult with a financial advisor or attorney.
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