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What Is Bankruptcy, and How Does It Work?

Maurie Backman is a personal finance writer who covers everything from savings to retirement to healthcare. Her articles have appeared broadly on major outlets such as CNBC, MSN, and Yahoo.

When you're drowning in debt with no end in sight, you may start wondering if you should file for bankruptcy. There are both benefits and drawbacks to taking this drastic step, so it's important to know what you're signing up for. Here, we'll discuss how bankruptcies work and help you decide if it's the right route for you to take.

What is bankruptcy?

Bankruptcy is a legal process that lets people or entities who can't pay their debts obtain some type of relief by having those debts either reorganized or eliminated. You can file for bankruptcy as an individual, a corporation, or a municipality.

How do bankruptcies work?

When you file for bankruptcy, your debts are either reorganized so they're easier to pay off, or wiped out so you don't need to pay some or all of them. The exact process depends on the chapter of bankruptcy you file for.

When should I declare bankruptcy?

You might consider filing for bankruptcy when your debts are such that you see no reasonable way to keep up with your payments. The purpose of bankruptcy is to give people (or companies or municipalities) a chance either to wipe out some of their financial obligations and start over with a clean slate, or to repay those obligations in a more affordable fashion.

However, to be clear, bankruptcy is not an option to consider if your debt is fairly new, or if you're going through a temporary financial crisis that's likely to improve (such as being out of a job). There are consequences associated with filing for bankruptcy, and it's most certainly not a "get out of jail free" card. So you should really consider bankruptcy only as a last resort if you've tried paying off your debts but keep digging yourself deeper into a hole.

Types of bankruptcy

Bankruptcy isn't a one-size-fits-all solution. There are different chapters of bankruptcy that apply in different circumstances. If you're filing for a personal bankruptcy, your choices are Chapter 7 and Chapter 13.

Chapter 7 bankruptcy

Chapter 7 is a personal liquidation bankruptcy. Your non-exempt assets are sold off by a court-appointed trustee to pay your debts to the greatest extent possible, and from there, your remaining unsecured debts are eliminated. (The amount of assets you can exempt varies from state to state.) Unsecured debts are those without collateral behind them -- debts like credit card balances and medical bills.

Qualifying for Chapter 7 is harder than qualifying for Chapter 13 because you'll be subject to what's known as the means test. If your income is lower than the median income in your state for a household your size (meaning, based on the number of dependents you have), you'll pass the means test and be eligible for Chapter 7. If you don't pass the means test based on income alone, you can deduct certain expenses, such as taxes, mortgage payments, and child care, from your income to see if it comes in under the necessary threshold.

If you don't pass the means test, you can either try again in six months and see if you qualify for Chapter 7, or otherwise pursue a Chapter 13 bankruptcy.

Chapter 13 bankruptcy

Chapter 13 is a personal reorganization of debt. If your earnings are too high to qualify for Chapter 7, you can file for Chapter 13. From there, your debts will be reorganized and possibly negotiated downward so that you're able to pay them off in a time frame of three to five years. You'll also be assigned a trustee to oversee that process.

One benefit of filing for Chapter 13 instead of Chapter 7 is that you'll get to retain your assets throughout the bankruptcy filing. Say you have electronic equipment or artwork you want to keep. Under Chapter 7, a trustee may be eligible to sell those items to repay your creditors, but under Chapter 13, you get to keep them.

Chapter 13 is also a good option if you own a home and want to keep it. You'll be given an opportunity under Chapter 13 to catch up on any mortgage payments you may have missed to stay in your home. Keep in mind that it's possible to keep your home under Chapter 7, too, but only if you manage to get current on your mortgage payments. Chapter 7 filings don't include provisions to help you catch up on missed payments, and if you have enough equity in your property, your trustee might choose to have it sold to pay off your creditors.

Another thing: Often, Chapter 13 filers have enough income to keep up with their mortgages, whereas Chapter 7 filers don't, which is also why you shouldn't lose your home under Chapter 13.

Other types of bankruptcy

Chapter 7 and Chapter 13 are your two choices when filing for personal bankruptcy. But there are a few other types of bankruptcy you might hear about in passing as you explore your options.

Chapter 9

Chapter 9 applies to municipalities -- cities, states, and other public entities like school districts are eligible for it when they can no longer keep up with their financial obligations. Chapter 9 debtors reorganize their debts in an attempt to pay creditors to the greatest extent possible, and the extent to which creditors are made whole depends on the level of assets and revenue the filer in question has.

Chapter 11

Chapter 11 is a corporate bankruptcy that allows companies to reorganize their debts, similar to a Chapter 13. Under Chapter 11, a company puts together a plan of reorganization that dictates how its existing debts will be paid. The purpose of Chapter 11 is to allow the company in question to keep operating. By contrast, Chapter 7 liquidations are available to corporations, too, only in that case, the filing company doesn't attempt to stay in operation, but rather, winds down its business and pays creditors off to the greatest extent possible.

Chapter 12

Chapter 12 is an option specifically for farmers and fishermen to reorganize their debts. It works much like a Chapter 13 bankruptcy, only to be eligible, you must be engaged in a commercial farming or fishing operation.

Chapter 15

Chapter 15 is a relatively new chapter of the U.S. Bankruptcy Code. Its purpose is to promote cooperation between U.S. courts and outside courts when a foreign entity files for bankruptcy.

How to file for bankruptcy

Your first step in filing for bankruptcy should be to consult with an attorney who can advise you on whether that's the right choice, and also, to let you know which chapter of bankruptcy is most suitable for you. From there, you'll need to gather certain documentation to help your attorney make that determination, such as:

  • Recent tax returns
  • Pay stubs or proof of income (or lack thereof) over the past six months
  • Bank account statements
  • Investment or retirement account statements
  • Copies of your mortgage or vehicle registration, if you own a home or car
  • A list of your existing debts
  • A list of all other notable assets you might have, such as artwork, jewelry, and other items of value

Before you're even allowed to file for bankruptcy, you'll be required to take a credit counseling course. Part of the purpose of that course is to help you determine whether bankruptcy is your best course of action.

Once you've completed that course, you'll need to file the bankruptcy forms associated with the chapter you're pursuing with your local court. An attorney can help you complete this step of the process. From there, a bankruptcy trustee will be assigned to oversee your case to perform the required tasks such as selling off your assets under Chapter 7, or ensuring that you're sticking to your personal plan of debt reorganization under Chapter 13.

How much does it cost to file bankruptcy?

The costs of filing for bankruptcy can be great. How much you’ll pay a bankruptcy attorney depends on where you live, the chapter you're filing, and how complex your case is. You can expect to pay between $1,000 and $1,500 for a Chapter 7, and between $2,500 and $3,500 for a Chapter 13, but these are just ballpark estimates.

You'll also need to cover the court fees associated with filing for bankruptcy, which are $335 for Chapter 7 and $310 for Chapter 13. You'll also pay a modest fee of $20 to $50 for your credit counseling course, but if your income is low enough, you may be eligible to have that fee waived.

Consequences of bankruptcy

Filing for bankruptcy might seem like a great solution to your debt-related woes. But there are repercussions you'll need to be aware of. For one thing, under Chapter 7, there's a good chance you'll lose your home, if you own one. You'll also risk losing other valuable assets, such as family heirlooms, jewelry, and other items worth money.

Additionally, bankruptcy proceedings are a matter of public record, which means the people you know could, in theory, find out detailed information about what your assets look like and how much money you owe. In other words, say goodbye to your privacy.

What happens to your credit?

Filing for bankruptcy is a sign that you're unable to manage your bills and debts responsibly. Therefore, your credit score will go down to reflect that. Oddly enough, the higher your credit score prior to filing for bankruptcy, the more of a hit it will take. By contrast, you'll feel less of an impact if your credit score isn't great to begin with. If your credit score is 700 or above, it could drop by a good 200 points with a bankruptcy filing. But if your score is lower, it might drop less than 150 points.

How long is bankruptcy on your credit score?

A Chapter 13 bankruptcy filing will stay on your credit record for seven years. On the other hand, a Chapter 7 filing will stay there for 10 years. During that time, you may have difficulty borrowing money, or borrowing affordably. You may also have difficulty getting approved to rent a home.

Where bankruptcy doesn’t help

Although bankruptcy is a good way to deal with unsecured debts, there are certain debts it won't wipe out. These include:

  • Back taxes owed to the IRS
  • Child support payments
  • Alimony payments
  • Debts resulting from you breaking the law, such as overdue fines

Also, filing for bankruptcy won't prevent you from losing your home if you're unable to get current on your mortgage payments and keep up with your future payments.

Other options

Clearly, there are some pretty extreme consequences you'll face when you file for bankruptcy, so it could pay to explore alternate options that make your debt more manageable. Here are a couple to consider.

1. Debt consolidation

Debt consolidation is the process of rolling multiple debts into a single loan. Doing so serves a couple of purposes. First, if your new loan comes with a lower interest rate than what's currently attached to your debt, you'll have an easier time paying it off, and it will cost you less money to do so. Secondly, having a single loan to keep up with means not having to risk missing different payments, or not having to keep track of multiple debt payment due dates.

You can consolidate your debt via:

  • A balance transfer, where you move your existing debts onto a single credit card. Some balance transfer cards offer a 0% introductory APR, the length of which depends on the offer you qualify for.
  • A personal loan, where you take out a new loan to pay off your existing debts, and then pay off that loan over time.
  • A home equity loan, where you borrow a sum of money based on the equity you've built in your home and pay off that single loan over time.

You'll need good credit to qualify for a balance transfer or personal loan. With a home equity loan, the requirement of having good credit isn't as stringent because your home is used as collateral for that loan. But if you fail to keep up with your payments, you risk losing your home.

2. Debt settlement

Debt settlement is the process of negotiating with your various lenders and creditors to reduce your existing debt to a smaller amount. Why would your creditors do that? It's simple -- they want to be paid, and if negotiating means they get something rather than nothing, it's a step they may be willing to take. For example, a creditor of yours might agree to accept 50% of your outstanding debt, knowing full well that if you were to go through the bankruptcy process, it could end up with a mere 10% of what it's owed.

You can attempt to settle your debt yourself, use a debt settlement company, or hire a debt settlement attorney. If you have a lot of debt to negotiate, the latter two options are worth pursuing.

While debt settlement can be a good solution for dealing with large sums of debt, one thing you should know is that your credit score will drop if you go that route, and any debts charged off by lenders could stay on your credit report for seven years, similar to a Chapter 13 bankruptcy. You'll also pay fees to settle your debts, which could eat into your savings. And forgiven debt is generally considered taxable, so you could get hit with an IRS bill if you go through with a settlement.

The bottom line on bankruptcy

The U.S. Bankruptcy Code exists for a reason -- to protect individuals (and other filers) who get in over their heads on the debt front and need relief. Filing for bankruptcy could be the best solution for dealing with your outstanding debt, or it could end up being a mistake you regret. If you’re even considering filing for bankruptcy, consulting with a bankruptcy attorney is a good idea because a lawyer can walk you through your options and help you weigh the pros and cons involved.

FAQs

  • Bankruptcy is a legal process by which debts are either reorganized or eliminated. Individuals, corporations, and even municipalities can file for bankruptcy.

  • When you file for bankruptcy, you debts will be either reorganized so they're easier to pay off, or eliminated completely. The exact process depends on the chapter of bankruptcy you file for.

  • Bankruptcy should be a last resort if you absolutely cannot keep up with the payments on your debts and have no other option.

  • First, you should consult with an attorney who can advise you on whether bankruptcy is the right choice. You'll also be required to take a credit counseling course before filing. From there, your attorney can help file the necessary forms related to the bankruptcy chapter you're pursuing.

  • For Chapter 7, expect to pay between $1,000 and $1,500. For Chapter 13, plan on $2,500 to $3,500. However, keep in mind these are ballpark estimates.

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