Understanding Bankruptcy

What is bankruptcy?

U.S. bankruptcy laws offer a fresh start to overwhelmed debtors. Bankruptcy can help you wipe out debt through discharge, create viable debt repayment plans or alter the terms of your debt.

Bankruptcy is a federal protection that helps people and businesses who can’t pay their debts. Most individuals who file bankruptcy choose between Chapter 7 (liquidation) bankruptcy and Chapter 13 (repayment) bankruptcy. The type of bankruptcy you file influences whether you need to sell your assets or make payments. It may influence how much of your debt gets canceled.

Even though most people shudder when they hear the word, bankruptcy can bring much needed financial relief. There’s a certain stigma around the idea of giving up on debts and seeking refuge in bankruptcy, but there’s no real reason to feel shame.

“Bankruptcy isn’t an easy solution or a coward’s way out, but people with a lot of motivation can sometimes avoid it,” said Max Smith, a certified credit counselor in Sacramento, Calif.

That being said, filing bankruptcy is a serious decision that requires a lot of thought.

In this guide, we’ll explain bankruptcy basics, so you can decide whether you should start talking with a bankruptcy attorney.

Note: If you are dealing with an insurmountable amount of debt and feel like bankruptcy is your only option, click below to see if you qualify for other debt relief options.

Debt Relief Options

Who should consider bankruptcy?

“You don’t do bankruptcy just for the fun of it, but I think bankruptcy is a good a thing, not a bad thing,” says John Colwell, president of the National Association of Consumer Bankruptcy Attorneys.

If you think you may be a candidate for bankruptcy, Colwell advises talking to an expert sooner rather than later.

“I don’t want to see people suffering without asking questions,” he says. “Being proactive and asking a [lawyer or credit counselor] the scary questions will help you make an informed decision.”

If you feel overwhelmed by debt, but you’re not sure whether bankruptcy makes sense, consider speaking with a non-profit credit counselor. This is a good way to pursue bankruptcy and its alternatives with the same meeting. By law, you cannot file bankruptcy unless you meet with a non-profit budget and credit counselor to review your spending habits.

The counselor may guide you towards alternatives to bankruptcy. On the other hand, the counselor may determine that bankruptcy makes a lot of sense for you. Smith sometimes counsels people to consider bankruptcy after a life-altering event. Health crises or income losses can make it tough to recover without bankruptcy.

There are other signs that you might need to consider bankruptcy. If you’ve turned to taking out car title loans or payday loans, you’re under-withholding your taxes from your paycheck, or you’re considering dipping into your 401(k) to meet your debt obligations, you might have enough debt to make bankruptcy a viable option, Colwell suggests.

Essentially, these are all signs that your debt is so overwhelming that your existing income isn’t sufficient to manage it.

When should you avoid bankruptcy?

If you earn too much to qualify.

Bankruptcy won’t always be the right choice. To discharge your debts through bankruptcy — that means your debts will be forgiven — you must prove that you can’t make the payments to your creditors. That means that people with high incomes may not get the debt relief they want through bankruptcy. Instead, they may have to file a form of bankruptcy that allows them to restructure their debts making it easier for them to make payments but not erasing the debts altogether. We’ll explain that later in this guide.

If you’ve recently filed bankruptcy.

Plus, bankruptcy won’t work if you’ve recently received a bankruptcy discharge. Legally, you cannot receive a Chapter 7 discharge if your you’ve received a Chapter 7 discharge in the last eight years, or a Chapter 13 discharge in the past six years.*

Likewise, you cannot receive a Chapter 13 discharge if you’ve received a Chapter 7 discharge in the last four years, or a Chapter 13 discharge in the last two years.

If you don’t have any assets at risk.

Even if you legally qualify to file bankruptcy, filing could be a waste of resources. Derek Caldwell, a bankruptcy attorney in Raleigh, N.C. explains that some people are “judgment-proof” so they should not bother with filing bankruptcy.

For example, a person with minimal assets, and no income except for Social Security income doesn’t have collectible assets. Social Security Income cannot be garnished to repay delinquent debts, and the person has no assets to seize. In that situation, filing bankruptcy is a waste of money, since their debts aren’t collectible.

Instead of filing bankruptcy, Caldwell advises opening a bank account that only holds social security income which protects it from creditors. Then you can send a cease communication letter to stop collectors from calling.

If you can afford to make payments by trimming expenses.

As a credit counselor, Smith helps clients build budgets, and lower their interest rates on existing debts. He challenges clients to track their expenses for at least 30 days, so they can find discretionary income. Additionally, he teaches clients to comparison shop and negotiate rates to lower their fixed expenses. These simple actions often help some clients avoid bankruptcy.

*Technically, you can file before six years if your total payments account for 100% of unsecured debt claims in your Chapter 13 bankruptcy. You can also file before six years if your payments account for 70% of unsecured debt claims and you made the plan in good faith and made your best effort to make the payments.

Types of Consumer Bankruptcy

Chapter 7

Chapter 7 bankruptcy is sometimes called liquidation bankruptcy. It’s called liquidation bankruptcy because you may have to sell some of your assets to pay off your debts. Once Chapter 7 bankruptcy completes, you receive complete debt relief (except student loans, most taxes, child support, alimony, court and criminal fines, and injuries from driving under the influence). This gives you an opportunity to start over without consumer debt. Chapter 7 bankruptcy discharge takes about four months to open and close.

To file Chapter 7 bankruptcy, you must submit a petition for bankruptcy. Your petition must include forms that explain your assets and liabilities (both secured by an asset, and unsecured) a budget that includes income (including disclosures of anticipated income) and expenses, a statement of financial affairs, contracts and leases, credit counseling certificate, your debt repayment plan, and two months of pay stubs. If you use a lawyer to file bankruptcy, expect them to charge their fee upfront. It’s not common to accept payment after filing according to Colwell.

Who qualifies for Chapter 7 bankruptcy?

To automatically qualify for Chapter 7 bankruptcy, you must earn less than your state’s median income (for a family of your size). Some people can qualify for Chapter 7 bankruptcy by submitting to means testing.

If you’ve filed bankruptcy in the past, you may not qualify to file Chapter 7 bankruptcy. You must wait eight years after filing Chapter 7 bankruptcy to file again. Likewise, you generally have to wait six years after filing Chapter 13 bankruptcy to file Chapter 7.

However, there are legal exceptions to the Chapter 13 rule. You can file chapter 7 bankruptcy again if your total payments account for 100% of the unsecured debt claims in the Chapter 13 bankruptcy or if you’ve paid 70% of the claims and you made the bankruptcy plan in good faith.

What happens to your debts?

In 99% of Chapter 7 cases, filers receive a discharge. That means they receive complete debt relief. However, most student loans, taxes, child support, alimony, court and criminal fines, and injuries from driving under the influence cannot be discharged in bankruptcy.

What happens to your assets?

Since Chapter 7 bankruptcy doesn’t involve a repayment plan, any repayment will come from your bankruptcy trustee selling off your assets.

This sounds bad, but you don’t have to worry that bankruptcy will completely clean you out. Certain assets including household goods, wedding rings, money in retirement accounts and medical supplies do not count towards your assets. Plus, you’ll be allowed to keep a certain amount (called an exemption). Exemptions vary by state, but the Federal bankruptcy act allows you to keep up to $15,000 of home equity and $2,400 of vehicle equity.

What to expect after discharge

The good news with Chapter 7 bankruptcy is that you get to start over right away. You don’t owe any payments, so you can begin rebuilding immediately. Of course, rebuilding can be difficult.

Your credit score will take a hit after you declare bankruptcy, but it may not be as bad as you might think. If you’re in such a tight spot with your finances that bankruptcy is a viable option, the odds are that your score is already low to begin with.

It will, however, make it hard to qualify for financing in the near future. Chapter 7 bankruptcy remains on your credit report for 10 years after discharge. Even with these factors working against you, you’ll likely see offers for credit cards and car loans. You can quickly rebuild your credit by using a credit card for your normal purchases. As long as you pay off the card in full each month, you won’t risk bankruptcy again.

“Counterintuitively, Chapter 7 bankruptcy might raise your credit score within 15 months,” Colwell says. “Most of my clients are solicited for car loans and credit cards immediately after filing for bankruptcy.”

In general, to get a new mortgage you’ll need to wait at least two years from discharge (for an FHA loan) or four years for a conventional loan.

Smith says he’s had clients successfully take out a mortgage just two years after filing Chapter 7 bankruptcy.

“It’s not the death sentence that people think it is,” he explains.

Who should consider Chapter 7 bankruptcy?

Anyone who does not need to protect particular assets should consider Chapter 7 bankruptcy. It’s a great tool for eliminating overwhelming payments, and it allows you to gain a financial fresh start right away.

Chapter 13

The other common form of bankruptcy (for individuals) is Chapter 13 bankruptcy. Chapter 13 bankruptcy requires you to create a debt repayment plan based on your expected income. You’ll make monthly payments on your debt for three years in most cases (but up to five years in select cases). After you’ve completed the payment plan, the court discharges the remaining debt.

Some people have to file Chapter 13 bankruptcy. For example, most people who earn more than their state’s median income will be required to file Chapter 13 bankruptcy.

However, some people opt for Chapter 13 bankruptcy to protect their assets. Chapter 13 bankruptcy generally allows you to keep all your assets, including your house and your car. Your debt repayment plan will prioritize any payments to your car or home loan, and it will state the requirements for retaining the title to your car or home. Legally, your debt repayment plan must provide more money to your creditors than if you liquidate your assets under a Chapter 7 bankruptcy.

In general, bankruptcy attorneys will include their fees in the payment plan. That means they won’t charge you upfront for their services (in most cases).

One of the most common uses for Chapter 13 bankruptcy is to save a home from foreclosure. In general, filing Chapter 13 bankruptcy stops foreclosure proceedings. It gives you the opportunity to create a repayment plan that will get you out of arrears. Of course, to save the house in the long run, you must continue to make your mortgage payments after filing.

Who qualifies for Chapter 13 bankruptcy?

Most individuals or businesses may opt to file Chapter 13 bankruptcy. However, you cannot file Chapter 13 bankruptcy if you’ve had debts discharged in bankruptcy too recently. If you’ve been discharged through a Chapter 7, 11 or 12 bankruptcy in the last four years, or a Chapter 13 bankruptcy in the last 2 years, you cannot file.

Chapter 13 bankruptcy also limits the amount of debt you can have. Right now, you can file Chapter 13 bankruptcy if you have less than $394,725 in unsecured debt (such as credit cards and personal loans) and $1,184,200 in secured debt (such as mortgages or car loans).

What happens to your debts?

In Chapter 13 bankruptcy, you repay some or all of your debts through a three to a five-year repayment plan. Over the course of three to five years, you have to pay your creditors at least as much as you would pay by liquidating your assets under Chapter 7 bankruptcy.

Whatever debt isn’t covered by the debt repayment plan is discharged after you complete the payment plan.

What happens to your assets?

In most cases, Chapter 13 bankruptcy allows you to keep all your assets.

“You can think of the Chapter 13 plan payments as buying back your house or your car,” Caldwell says. “You should have given it up in bankruptcy, but you get to keep it by continuing to make payments.”

If you don’t have enough disposable income to pay more than you could pay under Chapter 7 bankruptcy, you may be required to sell some assets.

What to expect after filing

After filing Chapter 13 bankruptcy, your payment plan will generally be approved within 45 days after your creditors’ meeting. You must make plan payments as agreed or risk further legal action against you.

Initially, you can expect your credit score to drop after you file for bankruptcy. The actual size of the hit will depend on how many accounts are part of the bankruptcy filing, and whether those accounts were already delinquent or charged off. If your credit score is in bad shape already, Chapter 13 bankruptcy will make it just a bit worse.

Unfortunately, your credit score may stay low for a prolonged period. This is because you cannot take out new consumer credit during your Chapter 13 repayment period. However, if you have current debts (such as a mortgage or auto loan), you can continue to make monthly payments as agreed. This will allow cause your credit score to climb even during bankruptcy.

Once you complete your payment plan, you can start rebuilding your credit score. The Chapter 13 bankruptcy will remain on your credit report for 7 more years, but you should start to see offers for credit cards and auto loans.

Two years after you complete your payment plan, you can start applying for mortgages.

Who should consider Chapter 13 bankruptcy?

If you don’t qualify for Chapter 7 bankruptcy, Chapter 13 bankruptcy may be the best choice for you. Chapter 13 bankruptcy also makes sense if you own certain assets that you want to keep. Just be sure that you have the cash flow needed to make your debt plan payments.

Chapter 11

Chapter 11 bankruptcy is usually reserved for corporations and businesses that want to continue operating during and after their bankruptcy. However, individuals (especially real estate investors or small business owners) may need to consider Chapter 11 bankruptcy based on the size of their debt.

Under Chapter 11 bankruptcy, the person filing bankruptcy (the debtor in possession) maintains control of all their assets while they create a reorganization plan. The plan is designed to pay back creditors using assets and disposable income over a five year period.

If you’re a small business owner with a partnership or corporation (rather than a sole proprietorship), Chapter 11 bankruptcy puts only your business assets and income at risk. Your personal assets (and those of your partners) is separate. On the other hand, Chapter 11 bankruptcy for sole proprietors includes both business and personal assets.

After you file Chapter 11 bankruptcy, you have four months to set up a reorganization plan. Your creditors must accept the plan before you can start making payments. If you don’t file a plan within 120 days, your creditors can file a competitive plan which can also be accepted by your creditors.

Who qualifies for Chapter 11 bankruptcy?

Any individual or business can file for Chapter 11 bankruptcy. However, most people who file Chapter 11 bankruptcy will do so because their debt exceeds the limits for Chapter 13 bankruptcy.

The current debt limits for Chapter 13 bankruptcy are $394,725 in unsecured debt (such as credit cards and personal loans) and $1,184,200 for secured debt (such as mortgages or car loans).

What happens to your debts?

Chapter 11 bankruptcy allows you and your creditors to change or modify existing loans. This is especially powerful for landlords who need to change the terms of their mortgages to become profitable again.

Any loans that are not changed must be paid on for up to five years following chapter 11 bankruptcy. After that, you will receive a full discharge on loans that haven’t otherwise been modified.

What happens to your assets?

As the debtor-in-possession, you have a lot of say over what happens to your assets. You can opt for a liquidation plan. This means you sell off certain assets to repay your creditors. On the other hand, you can keep all of your assets (provided that you make the plan payments.

What to expect after filing

After filing Chapter 11 bankruptcy, you’ll have to propose a reorganization plan. Then, at least half of your creditors (who own at least two-thirds of your debt) have to accept the plan. For some people, this can be a very contentious process. Most of your creditors have the ability to veto a plan, so you can expect to go through several modifications before a plan is accepted.

Once a plan is accepted, you’ll need to make payments for up to five years.

If you file Chapter 11 bankruptcy as a corporation or partnership, the bankruptcy may not hurt your personal credit score. However, your credit score will take a huge hit if you file as an individual.

Chapter 11 bankruptcy will remain on your credit report for 10 years from the day it is filed.

Unlike other forms of bankruptcy, Chapter 11 bankruptcy allows you to take out some forms of new credit right away. For example, you may be able to take out an auto loan or credit card as soon as you file. You can use these forms of credit to rebuild your credit score. However, you’ll have to wait up to four years after discharging the bankruptcy to get a new mortgage.

Who should consider Chapter 11 bankruptcy?

In general, most consumers should try for Chapter 7 or Chapter 13 bankruptcy before attempting Chapter 11 bankruptcy. However, small business owners may see advantages of filing Chapter 11 bankruptcy to avoid destroying their own credit.

Other forms of bankruptcy

In addition to Chapter 7, 11 and 13 bankruptcies, the U.S. Bankruptcy Act provides three other types of bankruptcy. These bankruptcy provisions are for municipalities, family farmers and fishers and people with international bankruptcy petitions.

Chapter 9 bankruptcy

Chapter 9 bankruptcy provides creditor protection for financially distressed cities and villages. The purpose of Chapter 9 bankruptcy is to help a city adjust the terms of its debts, so it can continue to make payments.

Chapter 12 bankruptcy

Chapter 12 bankruptcy is designed for “family farmers and fishers.” People in these occupations may have debts that exceed the limits for Chapter 13 bankruptcy, but they want a more streamlined bankruptcy than Chapter 11 bankruptcy. Chapter 12 bankruptcy includes repayment plans that last from three to five years, and they allow farmers and fishers to stay in business.

To qualify for Chapter 12 bankruptcy, farmers must have at least 50% of their fixed debts be related to farming. For fishers, the courts require that at least 80% of fixed debts must be related to the commercial fishing operation.

Chapter 15 bankruptcy

Chapter 15 bankruptcy provides laws and protections that help businesses and individuals who have debts and claims that involve more than one country. The law conforms to the United Nations Commission on International Trade Law.

How to File for Bankruptcy

Filing bankruptcy has long-term financial and legal repercussions. The U.S. Court system recommends consulting a bankruptcy attorney before filing. Smith advises his clients to meet with two or three lawyers before deciding on a particular attorney. It’s common for bankruptcy attorney’s to offer no-obligation meetings, so clients can learn about a lawyer’s fees and the process.

The process for filing bankruptcy can be costly.

The average Chapter 7 bankruptcy case costs between $1,309-$1,414 in out of pocket costs.

The average Chapter 13 bankruptcy costs $1,809 in out of pocket costs. If you cannot afford the fees, you may qualify for legal aid. Colwell cautions against bargain shopping for lawyers. “The range of prices can reflect a range in experience and quality. Be careful to choose a lawyer who knows what they are doing.”

Before you file for bankruptcy, you should also understand how long the process will take. Colwell estimates that the average Chapter 7 case takes about four months from filing to discharge.

A Chapter 13 cases can be in court anywhere from two to six months depending on the case complexity, but you’ll be “in bankruptcy” for three to five years while you make plan payments.

If you plan to file on your own

A lawyer can help you decide between Chapter 7 and Chapter 13 bankruptcy. They will also answer your questions, and file all the necessary forms for you. However, if you want to file for bankruptcy on your own, here’s what you need to do.

File the necessary documents

  • Filing bankruptcy requires you to submit at least seven documents right off the bat. These include a petition for bankruptcy.
  • You’ll also need to include schedules that list your assets and liabilities (both secured by an asset, and unsecured).
  • On top of those, you’ll need to include schedules that detail your income (including disclosures of anticipated income) and expenses.
  • If you have any open contracts, you’ll have to file a schedule of executory contracts or unexpired leases.
  • Also, you will need a statement of financial affairs which asks you to explain your current incomes, debts, payments and any financial hardships.
  • Additional requirements may include a credit counseling certificate, your debt repayment plan, and two months of pay stubs.

 

People filing Chapter 13 bankruptcy must also submit a repayment plan with their petition.

When filing Chapter 13, expect to pay a $235 case filing fee, and a $75 miscellaneous administrative fee. For Chapter 7 bankruptcy, you will pay $245 to file, $75 in miscellaneous fees, and $15 trustee surcharge when you file.

Automatic stay

Once you file, this automatically stops most (but not all) collections actions against you. You should not make any regular payments during this time. However, if you’re filing Chapter 13 bankruptcy, you must start making your monthly plan payments within 30 days of filing even if the plan hasn’t been approved yet.

Appointing a bankruptcy trustee

In Chapter 7 and Chapter 13 bankruptcy, the courts appoint a bankruptcy trustee to your case. The job of the trustee is to work with both you and your creditors in an impartial manner. The trustee will be in charge of liquidating your estate and disbursing the funds (in Chapter 7 bankruptcy) and receiving and distributing funds (in Chapter 13 bankruptcy)

Meeting of the creditors

Your case trustee will set up a meeting with you and your creditors within 21 to 50 days after you file. You must attend the meeting and answer any questions during the meeting.

Liquidation (Chapter 7 only)

Following the meeting of the creditors, your bankruptcy trustee may begin selling assets and paying your creditors. The trustee will only sell assets that aren’t exempt by federal law. If you want to keep your house or car, you may have the opportunity to reaffirm your debt on secured property like your car. This means you agree to continue making payments as agreed on the loan. You must reaffirm all loans before your property is discharged.

Plan confirmation (Chapter 13 only)

After the meeting of creditors, a bankruptcy judge will hold a hearing. During the hearing, the judge will decide whether you can realistically make the payments in your plan. They will also confirm that the plan meets the standards required. If the believes that your plan meets the required standards, she will confirm it. You will continue to make payments to your trustee. Payments will last three to five years based on the approved plan.

Discharge

The last step in bankruptcy is discharge. This means that your remaining debts are canceled, and cannot be collected. You will owe income tax on the amount of money discharged, so be careful to set aside some money to pay that tax.

Alternatives to bankruptcy

If bankruptcy doesn’t make sense for you, you still have options to lower your debt burden. Two alternatives include debt management plans (DMP) and debt negotiation. Debt management plans are a type of debt consolidation. In a DMP, a nonprofit credit counseling company negotiates interest rate changes on your behalf. In general, these companies specialize in lowering credit card interest rates. These companies charge a small fee for their services.

Another option is debt negotiation. If you’ve got cash saved up, a collections agent may accept a lump-sum payment to cancel your debt. They may accept as little as 25 cents for every dollar you owe, but you have to pay it immediately. Lawyers and debt settlement companies may offer to negotiate on your behalf. This option works best if you have cash saved up.

Below, we compare these options to the major consumer bankruptcy options.

Understanding Major Consumer Bankruptcy Options
  Debt Management Plans Debt Negotiation Chapter 7 Bankruptcy Chapter 13 Bankruptcy
Effects on Credit Negative due to showing accounts not paid as agreed. Neutral Est. 100+ point decline followed by slow recovery. Est. 100+ point decline followed by slow recovery.
Requires cash on hand? No Yes Attorney’s fees No
Debt Relief No Partial (Pay 20-75 percent of what you owe) Yes Partial
How long does it take to complete Up to five years of payments. Varies based on negotiation. Four months on average Two to six months for court; three to five years for payments
Time on credit report 7 years from the start of debt management plan 7 years from account delinquency Stays on report 10 years after discharge. Stays on report up to 10 years after payment plan completes.
Fees All fees must be clearly disclosed.

Setup fee (often under $100) + monthly fees (between $0-$75)

15-18% of total debt or 25% of savings (plus a monthly fee) On Average $1300-$1450 On Average
$1809
Tax implications Generally none. Canceled debt taxed as income in most cases. Discharged debt taxed as income in most cases. Any debt that becomes discharged taxed as income in most cases.
Deals with student loans Very few cases. Most companies only accept credit card debt. In some cases. Only in undue hardship cases. Only in undue hardship cases.