Forgive Us Our Debts...

Have you ever filed for personal bankruptcy? Ever consider it? You wouldn’t be alone. Nearly a million Americans file for bankruptcy every year.

And lucky for them, because the United States has the most liberal personal bankruptcy laws in the world.

The U.S. is one of only a few countries, in fact, where a person can walk into a courtroom, surrender 100% of whatever assets they currently own (often meaning no real assets at all), and walk out with all debts forgiven.

Very few countries have such a law. Rather than a mark of shame, however, our liberal bankruptcy laws may be one reason why the U.S. economy is more vibrant and entrepreneurial than the economies of most other countries. People in the U.S. are more willing to take investment and business risks, given the fact that the maximum penalty for a wrong decision isn’t as permanently ruinous as it is in most countries.

Bankruptcy laws in the U.S. also vary considerably from state to state, with some states allowing a person to retain all or a portion of the equity in their homes (called a “homestead exemption”) even as they declare personal bankruptcy. In one study, cited by Megan McArdle in her book The Upside of Down: Why Failing is the Key to Success, those states with unlimited homestead exemptions were found to have a 35% higher proportion of business owners among their residents.

And what events or data would you guess are the best predictors of a future bankruptcy? No, it isn’t the fact that you’ve lost your job, and no, it isn’t suffering some business or financial reversal. Nor is it going through a divorce, or suffering from a severe health problem.

No, the data show that the biggest single predictor of personal bankruptcy is simply the amount of debt a person has accumulated. The more debt you owe, all else being equal, the more likely it is that you will be filing bankruptcy at some point.

Debt makes a person’s financial situation brittle, and brittle things are subject to breakage.

The existence of debt means that any unanticipated economic setback could become absolutely ruinous. High levels of debt are what make it impossible to recover from a job loss or business reversal. When you’re in debt you are saddled with an ironclad, inflexible financial obligation, in addition to whatever other responsibilities you may have. You may or may not encounter some setback, but if and when you do, your indebtedness makes it more likely the setback could precipitate a bankruptcy.

Interest rates have been at record lows for nearly a decade now, but they will inevitably go up. They might not go up by much right away, but sooner or later they will definitely be higher than they are today.

So if you haven’t already begun trimming the debt from your own personal balance sheet, the time to begin doing so is now.

And who knows? It may be that paying down your debt will precipitate some entrepreneurial opportunities in your own life.