Generally, more than one factor will contribute to a situation that ends with someone becoming bankrupt. Irresponsible financial behavior, such as taking on too much debt, can be a factor, but other circ*mstances can also lead to a situation where someone chooses to file for bankruptcy. Here, we'll explore the top five ways people go bankrupt.
Key Takeaways
- A combination of financial setbacks can drive someone to file for bankruptcy.
- Factors that contribute to financial struggles can be either poor decisions or other circ*mstances that cannot be controlled.
- Job loss, medical expenses, and escalating mortgage payments are among the common reasons people file for bankruptcy.
- Overspending can also contribute to a situation that forces someone to file for bankruptcy.
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Five Major Reasons for Bankruptcy
Common reasons that people file for bankruptcy include loss of income, high medical expenses, an unaffordable mortgage, spending beyond their means, or lending money to loved ones. Often, bankruptcy is a result of several of these factors combined.
1. Loss of Income
Losing a job and a source of regular income can cause significant financial strain, especially if your wages are already stretched thin. A September 2023 survey found that 78% of Americans live paycheck to paycheck.
2. Medical Expenses
Medical expenses are another major factor contributing to bankruptcy. Medical problems can also lead to job loss in some cases. Or, if you've lost your job and your insurance, and you then suffer medical problems, you could also face financial strain.
There are several programs intended to ensure people who lose their jobs keep their health insurance. The Consolidated Omnibus Budget Reconciliation Act (COBRA) is a federal law that allows many laid-off workers to stay on their ex-employer’s insurance plan for a period of time. However, COBRA requires the employee to pay both their share and their employer’s former share of the insurance cost, plus an administrative fee, making it unaffordable for many people, especially when they’re out of work.
3. Unaffordable Mortgage/Foreclosure
Home mortgages are typically the largest portion of household debt in the United States, far surpassing credit cards, car loans, student debt, and all other categories. At the end of Q4 2023, according to the Federal Reserve Bank of New York, housing-related debt, which includes both mortgages and home-equity lines of credit, topped $12.61 trillion and accounted for approximately 72% of household debt in the U.S.
Lenders sometimes approve a buyer for a larger loan than they can afford to pay. People who accept these loans are at risk of losing their homes to foreclosure if they fail to make payments. They may also lose their job or face some other financial setback.
Some mortgages have adjustable rates, which means the homeowner's monthly payments can rise if interest rates rise. If a borrower suddenly faces a higher mortgage payment that they cannot afford to pay, they may be forced to file for bankruptcy.
4. Overspending
Overspending or living beyond your means can quickly result in unmanageable debt. If a borrower maxes out their credit cards by buying unnecessary items, and then cannot afford to make the minimum monthly payments, they can see their debt quickly snowball with interest costs.
To minimize the risk of overspending, create a budget that ensures income is greater than expenses. You can also work toward saving an emergency fund of several months' worth of expenses. This can help you cover an unexpected expense without having to go into debt.
5. Providing Financial Assistance
Sometimes, the need to provide assistance to relatives or others can be a factor in contributing to a situation that leads someone to file for bankruptcy. Whether they are providing support to adult children or aging parents, some people may find it difficult to decline financial assistance to a family member in need.
Other Reasons for Bankruptcy
Of course, there are many other reasons people file for bankruptcy. For example, some may have burdensome student loan debts. Although student loan debt is difficult to discharge in bankruptcy, it's not impossible. A new policy introduced in 2022 has made discharging federal student loans easier through a process called an adversary proceeding, which establishes that paying the loans may result in undue hardship.
Some borrowers may file for bankruptcy to eradicate other debt so they can afford their student loan payments. Other people may face financial strain as a result of divorce or separation, which can be costly due to legal fees.
Does Bankruptcy Clear All Debt?
Bankruptcy often clears your debt so you can start fresh with your finances, but it doesn't necessarily clear all debt. Debt that may not be cleared in bankruptcy includes alimony, child support, taxes, fines, and some student loans.
What Is the Downside of Bankruptcy?
Bankruptcy has the advantage of helping you start fresh with your finances, but it will have a negative impact on your credit score. A bankruptcy can stay on your credit report for up to 10 years.
Can You File for Bankruptcy While Getting a DIvorce?
You can file for bankruptcy at any time, but only one court process will occur at a time if you do so during a divorce. Consider whether you want to file for bankruptcy before or after a divorce.
The Bottom Line
Filing for bankruptcy can provide relief to people who are strained beyond their means with their debt. A number of factors can contribute to a situation where you may have to file for bankruptcy. To help avoid bankruptcy, you can take steps to stay in good financial health, such as only taking on an amount of debt you can afford to repay.
