5 Key Reasons People Go Bankrupt -- and How to Avoid Them | The Motley Fool (2024)

Here's some good news, and some bad, regarding personal bankruptcy: In the 12 months ending in June 2017, bankruptcy filings dropped by nearly 3%. Clearly, that's good. On the other hand, there were still a lot of bankruptcy filings -- 772,594, in fact.

It's instructive to look at why three-quarters of a million people end up filing for bankruptcy. Here are five key reasons, along with some tips on how to avoid becoming a bankruptcy statistic yourself.

Reason No. 1: Job loss

We're fortunate to be in a period of low unemployment right now, with the unemployment rate recently reportedto be 4.1% for the fourth month in a row. In contrast, it was around10% at the end of 2009, nearly 11% in 1982, and about 25% in 1933 during the Great Depression.

Losing a job can easily lead to bankruptcy if you don't have a well-stocked emergency fund that can cover all living expenses for six to 12 months. (Aim for more months if you want to be conservative and/or if it is likely to take you a long time to find work again.) You'll want to be able to pay for not only food and rent (or your mortgage), but also transportation, insurance, child-related expenses, utilities, taxes, home and car repairs, and so on. An emergency fund can also be tapped if you have a sudden major expense, such as medical bills -- just be sure to replenish the fund as soon as you can.

You probably can't completely wipe out your chances of losing your job, but there are some things you might do to reduce the odds. For example, being a valuable and productive worker with a good attitude can keep you on the right side of the retain/let go divide. You might also add skills and certifications over time, to make yourself eligible for additional kinds of jobs.

Reason No. 2: Income shrinkage

A more insidious reason that some people end up in bankruptcy is a reduction in their income. You may not completely lose your job, but if your hours are reduced by 25% or you're moved into a position that pays less, you can suddenly find it hard to make ends meet.

This is another kind of development that can be hard to avoid, but you can try to brace for it in the same ways you might brace for a possible job loss, as listed above. Another good idea is to keep an eye out for possible side gigs you might take on -- now, or if your income is reduced. For example, you might be a ridesharing driver on the weekends, sell crafts on Etsy, or do freelance writing or editing on the side.

Reason No. 3: Credit card debt

Credit card debt can be very dangerous, and it can snowball out of control if you let it -- especially if you have a bad credit card that's charging you interest rates of 25% to 30%, which is far from unheard of. Once you're carrying more debt than you can easily pay off, it can be tempting to just make minimum payments -- but that just drags things out longer and costs you much more in interest.

For example, if you owe $5,000 on a card that's charging you 28%, and you make only 4% minimum payments on it, it will takeyou 16 years to pay it off, and you'll be paying a total of about $11,700! That means interest alone will cost you more than $6,000, which is more than you owed in the first place.

The solution here? Don't let credit card debt accumulate and become a burden so large that bankruptcy looms. Only charge what you can afford to pay, and pay those bills promptly. If you're already saddled with onerous credit card debt, know that you probably can pay it off, and that many people have paid off debt loads of more than $100,000. One of the most effective ways to get out of debt is to pay off your high-interest-rate debt first. Those credit card rates of 20% or higher are much more costly to you than a 5% mortgage or car loan.

Reason No. 4: Medical expenses

Of course, sometimes it can seem hard to avoid racking up credit card debt, such as if you're suddenly faced with substantial medical expenses that you can't pay off easily. The medical treatment isn't likely to be optional, and healthcare is generally quite expensive. Thus, it's no surprise that medical expenses are a leading cause of bankruptcy.

It's tied to other causes, too, as medical expenses charged to credit cards will rack up debt that can be hard to get out of, and some hefty medical expenses might simply be insurance bought through COBRA after someone leaves a job. It's great to be able to continue your insurance through COBRA for a while, but it's often quite costly, sometimes $2,000 a month or more.

Those with major medical bills are more likely than the rest of us to declare bankruptcy. After all, when medical bills are steep, they tend to be really steep -- 5% of Americans account for 50% of the country's healthcare costs, accordingto a report in The Atlantic.Cancer patients were found to be twice as likely as non-cancer patients to declare bankruptcy, pera 2013 report.

Estimates differ on just where medical expenses rank as a cause of bankruptcy, rangingfrom about 25% of bankruptcies, to more than 50% and even 60%. (There are gray areas, too. Imagine, for example, someone who skips some mortgage payments to pay for medical bills and then files for bankruptcy protection. Was that due to medical bills or threat of foreclosure?)

You might aim to reduce your chances of having medical expenses wreak havoc with your financial life by getting and staying as healthy as possible. To do so, eat nutritious foods, exercise, and get all your preventive screenings.

Reason No. 5: Divorce

A final major cause of bankruptcy is divorce. Legal services alone, after all, can be costly, and assets are not always divided equally. Even if they are, the income and assets that used to support two people together successfully may not successfully support two people living separately. There may be substantial alimony and child support involved, too, and if one party is expecting but not receiving support from the other, it can leave that ex-spouse in dire financial straits.

Those are five top causes of bankruptcy, but they're not the only ones. Others include student loan debt (which is not easily discharged via bankruptcy), unexpected expenses, spending beyond one's means, steep utility bills, and the threat of foreclosure. Don't assume that bankruptcy will never be something you'll consider. Instead, take steps now to shore up your financial health and to reduce your chances of having to file for bankruptcy protection.