What Is Bankruptcy - a Complete Guide

Key Takeaways:

  • Bankruptcy is a legal proceeding conducted to relieve individuals or companies of debt while at the same time providing creditors with an option to pay.
  • Bankruptcy is dealt with by federal courts and the rules are set out in the US Bankruptcy Code.
  • Bankruptcy, commonly defined by their Chapter in the US Bankruptcy Code.
  • Bankruptcy may give you a fresh start, but it will stay on your credit reports for several years and make it harder to borrow in the future.

What Is Bankruptcy?

Bankruptcy is the very last resort for people drowning in debt.

Bankruptcy is a court proceeding in which a person requests to be relieved of their debts and liabilities so that they are no longer legally required to pay them.

You should know what to expect before you consider filing for bankruptcy. In this guide, you’ll learn how about the different types of bankruptcy and how to apply.

The bankruptcy process begins with the debtor submitting a petition, which is most common, or on behalf of the creditors, which is less frequent.

All the debtor’s assets are measured and assessed and the assets can be used to pay off part of the outstanding debt.

The judge and court trustee will first examine the assets and liabilities of an individual to determine if he truly cannot pay his bills.

Bankruptcy laws were introduced to give a second chance to people whose finances have, for one reason or another, collapsed. The majority of the time, such requests are granted.

Related: 5 Effective tips to get rid of debt

Who Declares Bankruptcy?

People who are bankrupt have far more debts than cash to cover them with no hope of ever recovering from the situation. One would think that businesses seek help more than individuals, but it is actually the opposite.

These individuals usually have one or more financial obligations, such as real estate holdings, mortgage, auto loans, and students loans.

If the person has no income to pay for these obligations, he would have to apply for one of the main two types of bankruptcy (read about the main types of bankruptcy below).

According to a 2015 study, there were 844,495 cases filed and 97% of them were filed by individuals. The amount has dropped in the years since but not significantly.

While bankruptcy may seem like a relief, it’s important to understand that it adversely affects one’s credit score and future ability to spend money.

It may prevent extreme legal actions by creditors such as home disclosure or wage garnishment, but there is quite a high price to pay.

Mortgage debt, credit card bills, and personal loans might overwhelm you, prompting the need to file a bankruptcy case.

If based on your calculations, you conclude that you will need more than five years to pay off all your debts, then it would be advisable to file for bankruptcy.

What Happens to Your Credit When You File for Bankruptcy

How will bankruptcy affect you and your credit? For starters, it can affect your credit score more acutely than any other single financial event.

While not all bankruptcies actually cause your score to drop significantly – in fact, it’s theoretically possible that your creditworthiness could increase after bankruptcy – any negative impact makes it more difficult to obtain credit in the future.

Filing for bankruptcy affects you differently as it appears on your credit report for years, providing a big warning to potential lenders about your troubled payment history.

Some creditors will reject an application immediately when bankruptcy is mentioned on your credit report.

Main Types of Consumer Bankruptcy: Chapter 7 and Chapter 13

These are the two main types of consumer bankruptcy:

  • Chapter 7
  • Chapter 13

Other types are Chapter 9, 11, 12, and 15, but Chapter 7 and Chapter 13 are the most common types. Under Chapter 7 bankruptcy, you can have all or part of your debts relieved after the sale of your liquid assets.

Liquid assets are assets that can be easily converted into cash.

Some of these liquid assets may be distributed among your creditors as repayment and any remaining debt is discharged.

Chapter 7 Bankruptcy

So, how do you qualify for Chapter 7 bankruptcy?

  1. Pass a means test to prove your income is less than the average state income for an individual;
  2. Once you pass the test, you will receive credit counseling within 180 days from an approved agency listed on the United States Courts website[1];
  3. You will be provided counseling either online or over the phone;
  4. You will then need to file the petition through a bankruptcy lawyer. Representing yourself is not recommended as the risk of losing is quite high. Most individuals may not fully understand federal bankruptcy laws which apply to their specific case;
  5. If you fail the means test for Chapter 7, you can apply for Chapter 13.

Chapter 13 Bankruptcy

These petitions make up about 30% of non-business bankruptcy filings. It involves paying off some of your debts so as to be forgiven the rest.

It mainly applies to people who have a significantly high income and do not wish to give up their property.

The total debts of people who apply for Chapter 13 bankruptcy should not exceed a certain amount. This amount varies and is reevaluated periodically. Check with a bankruptcy attorney first.

Under chapter 13, you will be put on a three to five-year plan to repay part or all of your debt. You will submit this repayment plan to the court after which you should begin making payments to the court.

It might be confusing and overwhelming to choose between these two main types of bankruptcy. If you have secured debt, such as a car loan, that you want to continue paying, you might want to choose to file Chapter 13.

If you prefer keeping these assets, Chapter 7 might be the best option for you.

What Happens When You File for Bankruptcy

The moment you are bankrupt, creditors cannot keep collecting their debts from you. They can’t go after any of your unsecured assets or make withdrawals from your bank.

Nonetheless, be aware that the filing process isn’t free. There are attorney and filing fees involved.

Once you file for bankruptcy, you may see a significant drop in your credit score. Individuals who have a high credit score might even see it drop by over one hundred points.

Also, Chapter 7 bankruptcy will tag on your report for ten years whereas Chapter 13, for seven.

A lot of people assume bankruptcy automatically wipes off all your debts. However, there are a few non-dischargeable debts:

  1. Tax Debts
  2. Debts for some fines and penalties
  3. Student loans
  4. Alimony and child support
  5. Debts for personal injury/death caused by drunk driving

Factors to Consider When Filing for Bankruptcy

Bankruptcy is not an option for everyone. It is good to carefully weigh your situation and see if you can fix your financial woes and avoid having to file for bankruptcy.

There are many consequences to think about. For instance, if you are having difficulty paying your mortgage, you may decide to file for Chapter 7 bankruptcy and have some of your debts forgiven.

Since this option allows for the sale of your liquid assets, you might lose valuable property, such as your own house.

With a high income, you are eligible to file for Chapter 13 and include your mortgage payments on your repayment plan.

It would also be wise to ensure your pension plans are safe. Most state laws will provide protection for pension plans and life insurance before a bankruptcy proceeding.

Other Types of Bankruptcies

As mentioned, the two main types of bankruptcy are Chapter 7 and 13. Let’s tackle a few others which aren’t as popular:

  1. Chapter 11 is designed for businesses and gives them a chance to reopen as it restructures its debts and assets. The main aim of this process is to aid businesses to pay their creditors back. It is used by large corporations like General Motors and United Airlines.
  2. Chapter 9 applies to cities or towns where an industry closes and employees have to work elsewhere. This protects municipalities from their creditors as it rearranges their affairs to have a repayment plan.
  3. Chapter 12 applies to fishermen and farmers. Debts should not exceed $4.03 million for farmers and $1.87 for fishermen. You need to receive a steady annual income in these respective occupations to qualify for this type of bankruptcy.
  4. Chapter 15 is applicable in a case where a debtor has assets and debts in the United States and other countries. The U.S court’s power is only limited to the assets a person has in the United States.

The Bankruptcy Means Test

The main objective of the bankruptcy means test is to assess whether a debtor truly qualifies for bankruptcy under Chapter 7.

The test is not applicable to disabled veterans who got in debt while active on duty. If a filer’s debt is a result of operating a business, he may file for Chapter 7.

The first step in the Means Test is to compare the debtor’s average income from the past six months. The debtor is eligible to file for Chapter 7 if his income is less than the State’s median family income.

A debtor may pass this Means Test but still be advised by a bankruptcy trustee to use his income in repaying creditors in a Chapter 13 repayment plan.

The income calculation will include:

  • Interest dividends and royalties
  • Wages, salary, tips, businesses, overtime hours, and commissions
  • Rental and real property income
  • Gross income from a business, farm, or profession
  • Annuity compensation
  • Worker’s compensation
  • Regular child support

The second step is when a debtor makes more than the median state’s income.

This second part of the means test will determine his eligibility for Chapter 7 bankruptcy. If his total disposable income is enough to pay part of his creditor’s debt, he is eligible for a Chapter 13 repayment plan.

As you can gather from this guide, there are many factors you need to weigh and study before filing for bankruptcy.

The best option would be to make an appointment with a bankruptcy attorney for professional and tailor-made advice for your specific situation.

Author Lorien Strydom

Lorien is the Country Manager for Financer US and has a strong background in finance and digital marketing. She is a fintech enthusiast and a lover of all things digital.

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Last Updated: July 20, 2021

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