The decision shouldn’t be easy. After all, you’re about to nuke both your credit and your credibility. But sometimes the hole you’ve dug is simply too deep.

By Liz Pulliam Weston

The bills are piling up. The collection agencies are calling. At night you lie awake, wondering how you’re ever going to cope with your debts.

At what point does it make sense to throw in the towel and file for bankruptcy?

There’s no one-size-fits-all answer to that question. In purely financial terms, the answer depends on:

• Your current situation.
• Your future prospects.
• The laws in your state.

There is, of course, another factor to be weighed, which is your personal sense of responsibility for repaying the debt you’ve incurred. We’ll get to that in a moment.

For now, let’s explore the purely financial and legal aspects of bankruptcy.

How the process works

A bankruptcy filing halts, at least temporarily, all collection activities, from phone calls demanding payment to more serious actions including foreclosure, wage garnishment and levies against your bank accounts.

What happens next depends on the type of bankruptcy you file:

• In the most common type of filing, Chapter 7, your credit card balances, medical bills and most other unsecured debts are erased entirely. (Certain other unsecured debts, like student loans and recent taxes, typically can’t be wiped out in bankruptcy.) Technically, some of your property could be taken and sold to satisfy your creditors; the types of property that could be taken vary by state. In some states, for example, only a small amount of home equity is protected from creditors, while in others like Florida and Texas the amount of equity that can be sheltered in a home is virtually unlimited.
• In Chapter 13 filings, you’re allowed to keep property that might otherwise be used to pay your creditors. In return, you agree to a plan to repay at least some of your debts over the next three to five years. If you complete the plan, the remainder of your eligible unsecured debt is legally erased.

Under 2005 federal bankruptcy reform legislation, you may be required to submit to a “means test” if you file for Chapter 7 and your income exceeds the median for your area. If the means test determines you can afford to repay some of your debt, you’ll be shunted into a Chapter 13 repayment plan.

Either way, your credit will be devastated for a while. Bankruptcy is the single worst thing you can do to your credit scores, the three-digit numbers lenders use to gauge your creditworthiness. That means, for a time at least, it will be more difficult and expensive for you to get credit.

Restoring your financial life

But bankruptcy also can give you a fresh start by wiping out old, troublesome debt. Rather than struggling to repay your bills for years or even decades, you can get started rebuilding your financial life. Those who get their act together and begin using credit responsibly often find that they can restore their credit scores to near-prime levels in just a few years. (Read “Bounce back fast after bankruptcy” for more details.)

In fact, the financial benefits of this fresh start are so profound that some experts say we shouldn’t be surprised that so many households file for bankruptcy. Rather, we should be amazed the numbers aren’t higher.

Back in the late 1990s, when about 1% of U.S. households were filing bankruptcy annually (compared to 1.8% in 2006), University of Michigan researcher Michelle J. White discovered that at least 17% of U.S. households would be better off financially if they filed. The percentage would balloon to nearly half of U.S. households if more people “prepared” for filing, by doing things like maxing out their available credit limits and transferring vulnerable property, like cash in the bank, into bankruptcy-exempt retirement funds.

Relatively few people game the system that way, however. Most arrive in bankruptcy court after exhausting every other avenue they can think of to pay their bills, according to Harvard University professor and bankruptcy expert Elizabeth Warren.

That’s borne out by a survey from the National Foundation for Credit Counseling. The organization polled its member agencies, which provide newly mandated counseling to consumers before they file for bankruptcy, and discovered only about 3% of those in pre-filing counseling had the means to repay any of their debt.

The fact that most people don’t rush into bankruptcy — many, if anything, wait too long to file — doesn’t answer the question of whether it’s right in your particular circumstance. Because beyond the financial and legal aspects is the fact that you’re reneging on debt that you promised to repay.

For some, that reality outweighs any benefit that they might receive from filing. Author Mary Hunt, who dug herself out of more than $100,000 in unsecured debt over 13 years, said she’s glad she didn’t even consider filing when she hit her financial bottom in the early 1980s. Hunt feels it would have been wrong to bail on her creditors and believes the long, often arduous task of repaying them helped her cure the overspending that got her into financial trouble in the first place.

“I really believe that had I not made that difficult U-turn on the road to total financial ruin — and the subsequent journey back to solvency, I would have never made the personal life changes necessary,” said Hunt, who runs the DebtProofLiving Web site. “Bankruptcy would have been too easy. And knowing myself, I would have been the perfect candidate for a repeat performance.”

Making a decision

Others, often with less debt, have come to different conclusions. Sometimes their bills have spiraled so high it would take a lifetime to repay, as is often the case with medical debt when someone who is uninsured gets hit with a serious accident or long illness. Or they see bankruptcy as a purely business decision: the lender made a business choice to extend them credit, after all, with all the risk that entails.

Personally, I have a hard time with people who feel no ethical qualms about filing for bankruptcy. The decision shouldn’t be that easy.

Most people in financial crisis have at least some responsibility for their situations. Carrying credit card or other high-rate debt and failing to have a rainy-day fund are two of the common ways people set themselves up for financial failure. Then when life’s inevitable setbacks come along — job loss, divorce, accident, illness — they’re quickly pushed over the edge.

You may not have been entirely responsible for the evils that befell you, but taking responsibility for your part is not only the right thing to do — it may help you stay out of trouble in the future.

If you use bankruptcy as an easy out and don’t fix the problem that led to your debt, you’re likely to get right back in the hole. This is especially true if your financial crisis is due to compulsive spending or an untreated addiction — to drugs, alcohol, gambling, whatever.

Be realistic about your dilemma

If, on the other hand, you’re putting off filing solely because of ethical objections, I’d ask you to be realistic about your situation and what it will take to rectify it. The United States outlawed debtor’s prisons more than a century ago, and to me it makes little sense to struggle for a lifetime with impossible debt.

In my view:

If, despite your best efforts, it would take more than five years to pay off your credit cards and medical bills, or you would need to use assets that would otherwise be protected in bankruptcy — like retirement accounts and home equity — then you should at least consult with a bankruptcy attorney about your options.

I choose the five-year period for a reason: That’s as long as a bankruptcy court would require you to stick with a repayment plan under Chapter 13. If you’re not sure how long it would take you to pay back what you owe without bankruptcy, consider a consultation with a legitimate credit counselor, one affiliated with the NFCC.

The credit counselor can help determine if your budget just needs an overhaul, if you’d benefit from a debt management plan with your creditors (see “The consumer’s guide to credit counseling“) or if your finances are beyond the counselor’s help.

Ultimately, of course, the decision whether or not to file is in your hands. Whatever any one else says, you’re the one who will live with the consequences.

Liz Pulliam Weston’s latest book, “Easy Money: How to Simplify Your Finances and Get What You Want Out of Life,” is now available. Columns by Weston, the Web’s most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money.