Understanding Bankruptcy
Seen as a last resort for most, filing for bankruptcy may erase debt, but can negatively affect your credit report for up to ten years. It also has a social and professional stigma attached to it. There are two types of bankruptcies: Chapter 7 and Chapter 13. Filing for Chapter 7 is the more common of the two. Also known as “liquidation bankruptcy,” this acquires all your assets in order to pay your debts, except those covered by the exemption law in your state.
The Types of Bankruptcy
There are six types of bankruptcy: Chapters 7, 9, 11, 12, 13, and 15. However, in 2019, 99% of bankruptcy cases filed were Chapter 7 (liquidation) or Chapter 13 (personal reorganization).
The remaining 1% consists of Chapter 11 (business reorganization), Chapter 9 (municipalities), Chapter 12 (farmers), and Chapter 15 (cross-border).
Chapter 7
Chapter 7 bankruptcy is often called “liquidation bankruptcy” because it allows most unsecured debts to be discharged by selling your assets. This includes debts like credit cards, personal loans, and medical bills.
It’s the quickest, simplest, and most common form of bankruptcy, but you must first qualify.
To qualify for Chapter 7, you need to pass Part 1 or Part 2 of your state’s means test. Part 1 is based on income. If your household income is lower than your state’s median income, you automatically qualify. Median income means that half of the people in the state earn more, and half earn less. If you earn less, you qualify for Chapter 7.
If your income is higher than the median, you can still qualify through Part 2 of the means test. In this part, you must provide documentation of all your allowable expenses from the past six months (such as rent, food, transportation, medical costs, etc.) and subtract these from your income.
The remaining amount, called “disposable income,” is what can be used to pay off your debt. If your disposable income is low enough compared to your debt obligations, you may still qualify for Chapter 7.
If you qualify, the court trustee will sell non-exempt assets to pay your creditors. Non-exempt assets vary by state, but they can include valuable items like a car, home equity, jewelry, art, collectibles, electronics, and more.
The Chapter 7 process typically takes 6-8 months to complete.
Chapter 13
Chapter 13 bankruptcy, also known as “reorganization bankruptcy,” allows you to propose a repayment plan to the judge, which enables you to repay creditors over 3-5 years without having to liquidate any property. To qualify for Chapter 13, you must have a steady income to make the required monthly payments.
There are also debt limits you must meet for Chapter 13. You can have no more than $394,725 in unsecured debt or $1.184 million in secured debt.
You will make monthly payments toward your debts for 3-5 years and are prohibited from taking out any new loans during this period. If you fail to make the payments, you may return to court and risk having your bankruptcy discharge revoked.
Chapter 11
Chapter 11 bankruptcy is similar to Chapter 13, but it is primarily used by businesses. It involves reorganizing or restructuring the company’s debts. While businesses can file for Chapter 7 bankruptcy, which leads to the liquidation of assets, Chapter 11 is often preferred because it allows businesses to retain their assets and continue operating. However, they must create a plan to repay some of their debt or have it forgiven.
What Does a Discharge Mean?
A discharge is a court order that frees you from the responsibility of paying certain debts. It means creditors and debt collectors must cease their efforts to collect, including stopping harassing phone calls and threatening letters. Essentially, a discharge is your way out of debt.
Which Debts Are Eliminated in Personal Bankruptcy?
Bankruptcy allows you to eliminate debts in the following categories:
- Credit cards
- Auto loans
- Mortgages
- Medical bills
- Utility bills
- Personal loans
Which Debts Are Not Eliminated in Bankruptcy?
The following debts are not forgiven in personal bankruptcy:
- Tax debt (though some IRS debt may be eligible for a payment plan)
- Alimony
- Child support
- Student loans
Creditors may also challenge any luxury item purchases or cash advances made immediately before filing for bankruptcy, arguing that they were premeditated transactions, potentially excluding them from discharge.
It’s also important to note that while a bankruptcy discharge protects you personally, it does not eliminate the debt itself. For example, if you had a co-signer on a home loan and file for bankruptcy, the lender can still pursue the co-signer for the debt. This is a key consideration if you have family or friends co-signing a loan but are not planning to file for bankruptcy.
What Are the Possible Effects of a Discharge?
The immediate effect of a bankruptcy discharge is a significant drop in your credit score, along with a note on your credit report indicating that you failed to pay your debts as agreed. This will remain on your credit report for 7-10 years.
The extent of the credit score decline depends on your score before the discharge. For example, if your score was above 700, you can expect a drop of 100 to 150 points. If your score was around 600, the drop is likely to be between 75 and 100 points.
Reaffirming a Debt
Reaffirming debt means you sign and file a legally binding document with the court, committing to repay all or part of a debt that could have been discharged in your bankruptcy case. Reaffirmation agreements must typically be filed with the court within 60 days after the initial creditors’ meeting. These agreements are entirely voluntary and are not required by the Bankruptcy Code or any state or federal law.
What Are the Consequences of Reaffirming a Debt?
If you reaffirm a debt and fail to make the required payments, the creditor can take action to recover any property pledged as collateral for the loan, and you may remain personally liable for any remaining balance.
Instead of signing a reaffirmation agreement, you can choose to repay the debt voluntarily. Reaffirmation agreements must not place an undue burden on you or your dependents and should be in your best interest. If you decide to sign a reaffirmation agreement, you have the right to cancel it at any time before the court issues your discharge order or within sixty (60) days after the agreement is filed with the court, whichever is later.
Bankruptcy Cost
Even if your finances are in poor condition, filing for bankruptcy can still be expensive. Hiring a bankruptcy attorney can cost several thousand dollars.
If you choose to handle your bankruptcy case on your own, the filing fees alone are significant, and your likelihood of success may be much lower.
According to the National Bankruptcy Forum, the average cost for a Chapter 7 bankruptcy is $1,250.
Bankruptcy and Its Impact on Your Credit Report
Chapter 7 bankruptcies will stay on your credit report for 10 years, while Chapter 13 bankruptcies remain for seven years.
Bankruptcy Education
As part of the bankruptcy process, there is a mandatory educational requirement.
Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, individuals must complete credit counseling within 180 days before filing for bankruptcy. This counseling provides information about the bankruptcy process and alternative debt-relief options.
After filing, individuals must also complete a pre-discharge course focused on personal financial management, which is required to have debts discharged. This course is designed to help prevent future financial challenges by teaching money management, budgeting, and responsible credit use.
Filing Bankruptcy Online
Many individuals now have the option to file for bankruptcy online, making the process easier for those who prefer a digital approach. Various platforms offer access to necessary forms and resources, allowing people to complete much of the paperwork from home. However, it’s important to understand the legal implications and seek professional advice before proceeding with an online bankruptcy filing to ensure all steps are properly completed.
Is Filing for Bankruptcy the Right Choice for Me?
Bankruptcy is often referred to as the “nuclear option” for debt relief because it should be a last resort, only after you’ve attempted – and failed – to manage your debt through other means.
If this applies to you, weigh the pros and cons carefully before making the decision to proceed.
Advantages of Filing for Bankruptcy
- Eliminates or reduces debt for individuals facing severe financial difficulties, such as due to illness or job loss.
- Provides temporary protection against foreclosure on a home or repossession of a car.
- Temporarily halts wage garnishment, harassment from debt collectors, and utility disconnections.
- Offers individuals a “second chance” to rebuild their finances.
Disadvantages of Filing for Bankruptcy
- Bankruptcy can impact your credit report for up to 10 years, making it difficult to secure loans for vehicles or homes.
- It becomes a public record, visible to potential employers, insurance providers, banks, and other lenders.
- Securing a mortgage after bankruptcy will be highly challenging.
- You may not qualify for loans for several years, especially mortgages or home equity loans.
- If you do qualify for loans, expect higher interest rates due to the increased risk.
Judgement Proof
“Judgment proof” refers to a person whose income is too low to pay off debts and whose assets are shielded from liquidation by federal law.
While they may own valuable assets such as Social Security, Disability benefits, retirement accounts, ERISA pensions, Veteran’s benefits, workers’ compensation, public assistance, child support, or alimony, these are protected under federal law and considered judgment proof.
The income from these sources is used to cover essential living expenses like rent, utilities, food, and clothing. Seizing this income to settle debts could result in homelessness and severe hardship, which is why it is legally protected.
Alternatives to Bankruptcy
If your income is too high for a Chapter 7 bankruptcy, there are other financial solutions available besides Chapter 13 bankruptcy.
The best way to effectively manage your debt is to contact a nonprofit credit counseling agency. Their certified counselors can review your budget or assist in creating one that helps you achieve a more manageable financial situation.
The goal is to identify the relief option that will best help you eliminate debt and regain control of your finances. And the best part? The service is FREE!
Some options that may be helpful include:
- Debt Management Plan — This plan can help you eliminate credit card debt over 3-5 years. Credit counselors negotiate with lenders to reduce interest rates, fees, and penalties to a more affordable level. In exchange, you agree to pay back the full principal over time in a structured manner.
- Debt Consolidation Loan — This option consolidates all your debts into one manageable loan with a lower interest rate. Be sure to choose a reliable debt consolidation company and avoid consolidating multiple unsecured loans into a secured loan, such as one backed by collateral like a home or car.
- Debt Settlement — Debt settlement involves negotiating with creditors to accept less than what is owed, sometimes up to 50% less. While this can be a good deal, it significantly damages your credit report, and many creditors may refuse to participate.
Is Bankruptcy the Right Choice for You?
Bankruptcy is shedding its negative reputation as more people recognize that a fresh financial start can be a positive opportunity. However, it’s important to approach the process with respect. Take advantage of pre-bankruptcy filing and pre-discharge courses to explore alternative debt-relief options and effective money management strategies.
Without the burden of debt, you can begin the journey toward financial recovery. Creating a budget, being mindful of spending habits, and applying for a secured credit card are initial steps to rebuilding credit. Managing loans and credit responsibly—such as paying bills on time—helps strengthen your credit over time.
If you’ve been given a second chance, make the most of it, but remember that the ultimate goal is to avoid bankruptcy in the future.