Bankruptcy: Will It Really Solve Your Problem?

Detail of Fulton County Courthouse in Rochester, Indiana by Derek Jensen via Wikimedia Commons used under licensed under the Creative Commons Attribution 2.5 Generic

I've driven by this courthouse dozens of time on the way to my Grandma's house, and always thought it was particularly attractive.

People file for bankruptcy for a variety of reasons, the most common being that they can no longer pay their monthly bills.  This can happen for a variety of reasons, such as loss of income or increasing expenses.

There are conflicting popular narratives as to why someone goes bankrupt.  Some say that it’s because households that file bankruptcy do so because they are spendthrifts who load themselves up with luxuries, and then bankrupt themselves to avoid the discipline of paying back what they borrowed.  Others say that bankruptcies are caused by unforeseen shocks to a households’ finances, such as sudden medical bills or job loss.  Regardless of the cause, I’d like to propose a simple question for people to ask themselves before filing for bankruptcy: “Will filing for bankruptcy solve your problem?”

Bankruptcy is frequently sold (yes, lawyers are selling their services) based on a series of immediate benefits to the person about to undergo bankruptcy.  One of the biggest selling points is that foreclosure proceedings stop and collection agents can no longer call them.  But, what are the long-term benefits to completing bankruptcy, and is it going to solve their problem?

Research suggests that, while sudden economic shock such as medical crises may precipitate bankruptcy, habitual over-consumption made the household unable to withstand the shock.  In a draft of “Household Consumption and Personal Bankruptcy [PDF]“, Professor Ning Zhu writes:

Such consumption looms particularly large put in the context of drastic difference in household income between the bankrupt and control households. Mortgage debt averages 1.93 times the bankrupt households’ average 2003 income, more than twice as large as the ratio of 0.79 for the control households. Similarly, the ratio of automobile loan to household 2003 income is 0.38 for the bankrupt households, again twice as large as the 0.19 for the control households. The credit card debts (with debts from banks) approximate one half of control households’ annual income and more than a full year’s income for the bankrupt households. In sum, our results suggest that households filing for bankruptcy tend to spend beyond their means before filing, which contributes to their filing decisions.

Here we see a pattern of systematic overspending and borrowing that financially weakens a household.  When a financial shock occurs, then the household collapses into bankruptcy.

So, my question becomes: “Will filing for bankruptcy solve your problem?  Especially when research indicates that your problem is that you think you can have more lifestyle than you are actually able to afford.  What steps are you taking to make sure your spending is in line with you means?  Are you starting a budget?  Are you going to commit to living only on what you earn, and not borrowing excessively?”

“Will filing for bankruptcy really solve your problem?”

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