When does filing for bankruptcy make sense? How do I know if I should file Chapter 13 or Chapter 7?

Unfortunately, the options for those facing severe financial hardship are anything but easy. Most commonly, the choice is either years spent slowly chipping away at the debt through a debt management program, or declaring personal bankruptcy -; which offers the opportunity to wipe out many debts, but typically comes at the price of losing belongings and then spending years struggling to rebuild credit. Fact is, while there may be a perception that bankruptcy is an easy way out, the vast majority of those who use it aren't taking advantage of the system, says Travis Plunkett, legislative director of the Consumer Federation of America. They simply have no reasonable alternatives.

That said, knowing whether bankruptcy is the right move is a highly personal decision and depends on numerous factors including the debtor's age, the number of creditors they have and their employment situation, says Karen Gross, a professor at New York Law School and author of the bankruptcy book "Failure and Forgiveness." The key, experts say, is to start exploring options at the beginning of a debt crisis, rather than at the point where one's credit is already severely damaged and the debts have become insurmountable. "Don't panic and get advice early," says Gross. Your options will be much more limited, she says, if you wait until you have a full-blown emergency on your hands, such as judgments against you or foreclosures.

So what are some signs that your debts could be approaching dangerous levels? According to the National Foundation for Credit Counseling, some common indicators are when bill collectors start to call and write; when credit cards are being used to pay for necessities like groceries; when you start to fall behind on the basics such as rent and utilities; when you are skipping some bill payments to pay others; and when 20% or more of your take-home pay is being used to pay debts. For those who are already experiencing any of these scenarios, one stroke of bad luck -; such as job loss or illness -; could easily tip the scales to financial ruin.

The first step for those considering bankruptcy is to educate themselves. Consumer-oriented bankruptcy books are available at most public libraries. Gross also suggests a book published by Nolo called "Money Troubles: Legal Strategies to Cope With Your Debts." (Nolo also offers books specifically on personal bankruptcy.) Once one has a basic understanding of his options, he may then want to talk to a professional, namely a bankruptcy attorney or a debt counselor. For those who choose the latter, keep in mind this is an industry that is partially funded by the credit-card companies, so an unscrupulous counselor may discourage clients from declaring bankruptcy, even when it makes the most sense. A good place to begin a search for a reputable credit counseling service is through the National Foundation for Credit Counseling's Web site. For more on this, see our story.

Should one decide that bankruptcy is the best option, the question then is whether to declare Chapter 7 or Chapter 13. Chapter 7 is the most common. With this type of bankruptcy, most debts (with a few exceptions, including student loans as well as federal and state taxes) are wiped out. But under current law, just how much a debtor will lose to the creditors depends on the state, explains G. Ray Warner, resident scholar at the American Bankruptcy Institute. For instance, some states, like Florida, allow those declaring Chapter 7 bankruptcy to keep their homes. Others only allow a small amount of home equity to be exempt. Once the bankruptcy has been "discharged" (meaning you've been legally cleared of your debts), Chapter 7 bankruptcies will stay on a credit report for 10 long years. As time goes on, this doesn't mean that you won't have access to any credit, mind you, but it certainly won't be at the best rates.

Under Chapter 13 bankruptcy, the debtor comes up with a repayment plan over the next several years. The incentive for this is that he will be able to retain some secured debts, like a home or a car. The bankruptcy will also be listed on the credit report for seven years (as opposed to 10). In order to file Chapter 13, the debtor must have some income to continue to pay off the debts. Unfortunately, many folks who file Chapter 13 are unable to keep up with their repayment schedule, and then convert to Chapter 7.

It's also worth noting that the bankruptcy laws could change in the near future. For the past few years, a bankruptcy reform bill that would tighten the personal bankruptcy laws has been batted around Congress. And while this bill -; which has wide bipartisan support -; is currently dead, it's likely to be reintroduced in early 2003 in essentially the same form as seen previously, or perhaps in even a stronger version, says Warner. The bill largely favors the credit industry and would include a federal "means testing" formula, which would force some debtors to file Chapter 13 bankruptcy rather than Chapter 7. Should it pass, it will take effect 180 days after the bill has been signed.

This looming legislation is just one reason why those currently considering bankruptcy should become educated on their options. Perhaps a more important reason is that those suffering financial distress are often tempted to ignore the problem, hoping it will go away. But without taking some sort of action -; even if it's simply knowing how much you owe and creating a budget that will allow the debt to be slowly repaid -; most financial problems only fester. So should you feel yourself slipping, start tackling the problem today.

For more on this, visit our debt management section.