How Does Bankruptcy Work And Is It Right For Me?
Debt can get away from you quickly. Regardless of how you accumulated it, the constant collection calls, threatening letters, and sleepless nights ultimately take their toll. Running through options in your head, you’re beginning to wonder how bankruptcy works and if it might be the right move for you.
Let’s look through some of the main components of bankruptcy so you can determine if it’s an appropriate solution for your situation.
Note: Most information for this article was taken from the United States Courts.
What is Bankruptcy?
Bankruptcy is a federal legal process freeing people or businesses from unmanageable debt by either discharging the debt or creating a workable repayment plan.
Once you file for bankruptcy, your creditors are notified and must temporarily stop contacting you or proceeding with other collection or legal action. Once your debts are discharged, you are no longer responsible for them.
The U.S. Bankruptcy Code governs bankruptcy. For individuals, there are two types of bankruptcy: Chapter 7 and Chapter 13.
How Bankruptcy Works in Each Chapter
While both chapters provide debt relief, they do so in different ways.
Chapter 7 usually results in a discharge of your eligible debts soon after approval of your petition.
Having your debt wiped away probably sounds like a relief, but it may come with a hefty price tag. Under this chapter, your non-exempt property could be liquidated to satisfy your creditors.
What constitutes as exempt vs. non-exempt property varies by state. But, in general, if you have things like jewelry, valuable collections, investments, real estate outside of a primary residence, or you have lots of equity in the home you live in, you may lose these assets in the bankruptcy proceedings.
A court-appointed trustee will liquidate your non-exempt property, if applicable, and disburse the proceeds to your creditors.
Note: With a chapter 7 bankruptcy, you have the option to reaffirm a debt. If you want to keep your car, for example, you could enter into a legally approved repayment plan with your creditor to retain the vehicle. This agreement must be made before your debt is officially discharged.
Bottom line: if you have a lot of assets, chapter 7 bankruptcy may not be a good solution for you.
Successful chapter 13 filings result in a 3 or 5-year debt repayment plan. If you qualify, this chapter can allow you to keep your home, rather than potentially having to liquidate it under chapter 7.
If you make less than your state’s median income, the repayment period will last for three years. Or, if you make more than the median, you’ll make payments for five years. During your repayment period, creditors cannot initiate or continue collection efforts.
Your payments will be all of your disposable income. For this purpose, your disposable income is your gross income (excluding child support), minus what the court deems reasonable to maintain your household and your charitable giving (up to a maximum of 15% of gross income).
Your repayment plan will address priority, secured, and unsecured debt. Priority debt is taxes and bankruptcy court costs. This debt must be paid first. Secured debt is tied to collateral (such as car loans and mortgages). Unsecured debt, such as credit card debt, is not backed by collateral.
For secured debt, the creditors need to be paid at least the value of the property.
Depending on when you bought it (usually a car) in relation to when you file for bankruptcy, you may be liable for the full amount owed. With a mortgage, you may continue paying on it after the bankruptcy repayment period as long as you have brought the account to current during that time.
For unsecured debt, you do not have to pay off the full amount owed. (Though it may happen depending on how much you owe and how much you pay over the repayment period.) However, if a creditor does not receive payment in full, you need to ensure they received at least what they would have gotten if you had liquidated under chapter 7.
If you make all of your required payments and still have remaining eligible, non-mortgage debt, it will be discharged at the end of the repayment period.
Note: to receive the discharge, you must also complete an approved financial management course. Additionally, you cannot have received a chapter 13 discharge within the last two years or a chapter 7 discharge within the last four years.
Who is Eligible to File for Bankruptcy?
To be eligible to file for bankruptcy, within the last six months, you:
- Must have completed credit counseling
- Must not have had a bankruptcy case dismissed due to non-compliance with the court
- Must not have dismissed your own bankruptcy case to prevent creditors from recovering property
Additionally, each of the chapters has its individual requirements.
For Chapter 7
To qualify for chapter 7 with mostly consumer (non-business debt), you’ll need to pass a means test.
The court needs to assess if you have the financial resources to satisfy your debts. The test looks at whether your income for the past six months is below the median income of your state. If it is, you passed the test and can proceed with the filing.
If it’s not, you still have the opportunity to demonstrate financial need by reporting your essential living expenses like shelter, food, medicine, etc. to the court. Then, if your disposable income after expenses meets the court’s criteria, you may still pass the means test and proceed with chapter 7 filing.
If you don’t qualify for chapter 7, you may be able to convert your filing to a chapter 13.
For Chapter 13
To qualify, you must have less than $394,725 in unsecured debt and less than $1,184,200 in secured debt. (There are no debt limits for chapter 7.)
What is the Filing Process?
Regardless of which chapter you file under, the process has many similarities. To begin, you must file a petition with your local court.
As part of this step, you will need to provide the court with:
- Information about your assets, debts, income, and expenses
- Recent tax returns
- A credit counseling completion certificate from an approved agency
If you created a debt repayment plan during your credit counseling, you must submit that, too. If you are filing with your spouse, both of you must provide the information above.
Next, you will be assigned a court trustee. They will arrange and preside over a meeting involving you and your creditors.
You will be asked a series of questions under oath to gain clarity about your financial situation and to ensure you understand the bankruptcy process and implications for your financial future.
The findings of this meeting will be summarized and presented to the court. Then, your case will be heard, and a bankruptcy judge will approve or deny your petition.
Chapter 13 Process Nuances
How Chapter 13 bankruptcy works is a bit more complex than chapter 7 as it requires the creation, approval of, and adherence to a debt repayment plan.
With a chapter 13 bankruptcy, you must submit a repayment plan to the court within 14 days of filing. You also need to make payments to your court-appointed trustee within 30 days of the plan’s creation even if your case hasn’t been heard yet.
Within 45 days of the meeting with the creditors, a judge must hold a confirmation hearing. Creditors will be notified and may contest if they feel the repayment plan is unfair.
If the court confirms your repayment plan, your trustee will start paying your creditors. If the court denies your plan, you can attempt to submit a modified plan or convert your filing to a chapter 7 liquidation.
Chapter 13 bankruptcy is a long process. You must strictly follow your repayment plan. If you want to take on any additional debt, you must get approval from your trustee first as it could compromise your ability to make payments as agreed.
If you fail to make payments, your case could be dismissed or automatically converted into a chapter 7 liquidation. However, if you become unable to work, you may qualify for a hardship discharge, which would absolve you from making additional payments.
How Much Does a Bankruptcy Cost?
You will incur two main costs — court costs and attorney fees. The court costs are straightforward but vary slightly depending on the chapter you file under.
For chapter 7, it costs $245 to file the case, $75 in administrative fees, and $15 for a trustee surcharge. For chapter 13, it costs $235 to file the case and $75 in administrative fees.
Court costs can be paid in installments with approval. However, failure to pay them could result in the dismissal of your case. For chapter 7, If you make below 150% of the poverty level, the court fees may be waived.
Legal fees, unfortunately, are not as cut and dry and vary dramatically based on your location, the complexity of your case, how experienced your lawyer is, and other factors. You can expect to pay several hundred to several thousand dollars to your bankruptcy attorney.
What Debt Gets Discharged?
Many types of debt such as car loans, mortgages, and credit card balances can be discharged in bankruptcy. Not all debt is eligible, however.
While there are additional, uncommon nuances for both chapters, in general, the following debts cannot be discharged:
If your primary source of debt is federal student loans, a standard bankruptcy filing may not help you much. However, you have the option of filing a separate adversary proceeding to have the bankruptcy court determine if your student loan payments create an undue hardship for you. If the court rules in your favor, your student loans could be discharged.
What Happens to My Credit Score?
Declaring bankruptcy will cause your credit score to plummet — potentially by 200 points or more. The severity of the drop depends on how much debt was discharged.
The impact on your credit is long lasting. A chapter 7 bankruptcy stays on your credit report for ten years, while a chapter 13 bankruptcy lingers for seven years. However, with diligent credit management post-bankruptcy, your score can vastly improve in half of that time.
It’s important to note that collections, judgments, and garnishments also wreak havoc on your score. So if the credit blemishes are piling up, it may be prudent to stop the bleeding by declaring bankruptcy.
What are My Alternatives to Bankruptcy?
Declaring bankruptcy is a drastic move that will impact your future. While it may ultimately be necessary, considering alternatives is part of doing due diligence. The earlier you notice the problem and take action, the higher the chance other options will work.
Here are some ideas to explore:
- Improve cash flow to allocate toward debt by paring down expenses, augmenting income, selling items, or asking family or friends for a loan.
- Ask your creditors for help. They may be able to reduce your payment amount, interest rate, or both, to get you back on track.
- Seek credit counseling. Since it’s a requirement to file for bankruptcy anyway, it’s worth seeing if this route can get you out of financial trouble. Click here for a list of approved agencies.
- Settle past due accounts. You may be able to pay your creditors a reduced amount and avoid going to court.
How Do I Recover From Bankruptcy?
If you do go through with bankruptcy, it’s important to start rebuilding your financial life right away. While it takes a long time for your credit score to recover, you have a lot of say in how quickly it gets healed.
Here are some steps to take post-bankruptcy:
- Understand why this situation happened. If poor money habits were the culprit, develop a plan to ensure that history doesn’t repeat itself.
- Make and stick to a budget.
- Start rebuilding your credit by responsibly using it. Consider getting a secured credit card.
- Keep track of your credit by obtaining regular free credit reports.
- Build up an emergency fund, so you don’t need to be reliant on credit in a financial jam.
This article is only meant to provide general information on how bankruptcy works. If you’re seriously considering this route, we encourage you to speak with a lawyer who specializes in bankruptcy law in your state. While you can represent yourself in court, a lawyer can guide you through bankruptcy’s many nuances, so you get the best possible resolution.
Article written by Laura