Should I Repay Debts Before Filing for Bankruptcy?

Paying debts before filing for bankruptcy might seem wise, but it can lead to problems later. And you certainly don't want to pay debts you could erase in your bankruptcy. In this article, you'll learn:

• how to decide whether to pay debt or file for bankruptcy
• whether it makes sense to repay debt before bankruptcy, and
• the problems with paying favorite creditors before a bankruptcy filing.

For instance, if you repay a debt within three months before filing, or within a year if the debt was to a family member or business associate, the bankruptcy trustee can sue the creditor to get the money back in a "clawback suit."

Is It Better to Pay Off Debt or Declare Bankruptcy?

If you're considering paying debt before bankruptcy and asking whether you need to file or should avoid bankruptcy altogether, the simple answer is, "It depends." Deciding whether to file for bankruptcy or pay off debt is a cost/benefit analysis, and you'll want to ask yourself the following questions:

1. How much debt can you erase in bankruptcy? Not all debt qualifies for a bankruptcy discharge, the order wiping out qualifying debts at the end of a bankruptcy case. Find out how much you can erase by learning about nondischargeable debts.
2. How much property will you lose in bankruptcy? Everyone can keep the basic things needed to work and live after bankruptcy. But that's it. Check your state exemption laws to learn whether you'd lose property in Chapter 7 or if you'd need to pay to keep property in Chapter 13.
3. How long would it take to pay off your debt? Bankruptcy will impact your credit score, but the hit lessens over time. Debts that remain unpaid will keep your score down for many years, and many people find improving credit easier after eliminating bad debt in bankruptcy.

Answering these questions should help you determine whether bankruptcy is right for you. Also, consider getting a second opinion by consulting a local bankruptcy lawyer. They often offer a free consultation.

Is Bankruptcy Worse Than Debt?

Again, it depends on whether you'll be able to pay off your debt soon. Sometimes it makes sense to negotiate debt with a creditor if you can pay off the negotiated amount. Credit scores usually rise more quickly after eliminating significant balances than a bankruptcy filing.

However, it's a good idea to make sure you'll be able to pay off all of your debt before paying down one account. Why? Because it's not uncommon for some creditors to negotiate, but not all. You don't want to waste money by paying off a debt settlement only to find that you can't afford to pay off the others and must file for bankruptcy anyway.

Also, it's possible to end up owing taxes after negotiating down debt. Your bankruptcy lawyer or tax accountant can explain the ramifications and what to do if you find yourself taxed after a debt settlement. Learn more about taxes in bankruptcy.

What Amount of Debt Is Worth Filing Bankruptcy?

You don't need a particular amount of debt to file for bankruptcy. Instead, ask yourself how long it would take to pay off your debt. Most people find they can pay off less than $10,000 over time and would want more than that before filing.

You'll also want to factor in bankruptcy waiting periods. For instance, you can receive a Chapter 7 discharge once every eight years, but not sooner. So it's a good idea to hold off on using your bankruptcy if it isn't entirely necessary because you might need it to correct a more severe financial situation in the future.

If You Choose Bankruptcy, Should I Repay Debts Before Filing?

Most filers don't find paying debts before bankruptcy beneficial, and sometimes it creates problems (we explain why in the next section). However, it can be tempting because sometimes, filers don't want the bankruptcy discharge to erase a particular debt.

Filers have numerous reasons for wanting to pay off an obligation, including:

• ensuring a debt owed to a friend or close family member is satisfied
• hiding the bankruptcy filing from a bank, employer, or creditor
• protecting a creditor the filer believes is deserving, or
• preserving a relationship with a creditor, such as a supplier or medical provider.

Often, a desire to repay a debt before bankruptcy is based on a misunderstanding of how bankruptcy works. For instance, you probably can't keep a credit card open by paying it off before bankruptcy.

Most credit card companies run periodic credit checks and will become aware of your bankruptcy filing even if you don't list the "zero balance" account in the bankruptcy.

Why Paying Debts Before Bankruptcy Can Be a Bad Idea

If you're still considering paying off debts, here are a few reasons why paying off debt before filing bankruptcy can cause problems for you and the person or business you paid.

Repayment Might Be a Preferential Transfer

Paying a creditor before filing could be a "preferential transfer" violating the bankruptcy payment rules that protect creditors from unfair payment practices. Simply put, preferential transfers—payments made to the "preferred" creditors of the filer's choice—aren't fair. Here's why.

• By selecting which creditor to pay, the filer decides how much creditors should receive instead of filing bankruptcy payment laws.
• Paying one creditor more than what they'd be entitled to leaves other creditors with less than they'd be entitled to receive.

The bankruptcy court has a system for correcting this wrong.

The Court "Claws Back" Preferential Transfers

Both Chapter 7 and Chapter 13 trustees are responsible for recovering funds for creditors when appropriate. So you can bet that when a preference payment occurs, the bankruptcy trustee appointed to the case will try to get the money back through a "clawback" action.

How Far Back Does the Bankruptcy Court Look?

If you made a preferential transfer to a creditor within the 90 days before you filed for bankruptcy, the trustee can file a clawback suit and try to obtain the funds from the paid creditor.

If you repaid a close friend or family member, sometimes referred to as an "insider," the time that a court will consider extends to a year before the filing.

What Happens in a Clawback Suit?

In a clawback suit, the trustee brings a lawsuit against the creditor you paid off to get the money back. A clawback suit can cause several problems with your bankruptcy.

• The result can be messy. The trustee could sue family members, employers, medical providers, and anyone else you paid.
• If the court finds that you paid a creditor to hide assets, it might deny your entire discharge, a common occurrence when a filer pays off a close friend or family member.

What Debts Can You Pay Before a Bankruptcy Filing?

Not all payments made before bankruptcy will be preferential transfers. You can pay your usual bills, such as your rent or mortgage, car payment, utility bills, and the like. The trustee will examine your transfer disclosures in your paperwork for unusual payments triggering red flags.

Again, you'll list all of the following payments in your bankruptcy paperwork:

• payments of $600 or more made within 90 days of filing, and
• payments made to insiders, such as relatives, business partners, and close associates, regardless of the amount during the year preceding bankruptcy.

You'll also check whether the payment was for your mortgage, car payment, credit card, or fill in the debt type. Interestingly enough, you'll list domestic support payments under the second category because funneling money to family members is the most common way people try to hide money from creditors.

Payments made for your mortgage or car payment likely won't be a problem. The trustee will probably take an interest in large payments toward credit card debt, medical bills, and other debts you can discharge when your bankruptcy case ends.

Keep in mind that the trustee can compare your paperwork disclosures to other financial documents like your bank statements.

Can I Pay Debts After My Bankruptcy Discharge?

Absolutely. If you want to ensure a creditor gets paid, the best way to do this is after the bankruptcy. Nothing prevents you from paying off a creditor with your postbankruptcy earnings after receiving a discharge.

Navigating Your Bankruptcy Case

Bankruptcy is essentially a qualification process. The laws provide instructions for completing a 50- to 60-page bankruptcy petition, and because the rules apply to every case, you can't skip a step. We want to help.

Below is the bankruptcy form for this topic and other resources we think you'll enjoy. For more easy-to-understand articles, go to TheBankruptcySite.

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.