What Happens When You File Bankruptcy?
Bankruptcy is a legal life line for people drowning in debt. Consumers and businesses petition courts to release them from liability for their debts. In a majority of cases, the request is granted.
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What Is Bankruptcy?
Bankruptcy is a court proceeding in which a judge and court trustee examine the assets and liabilities of individuals and businesses who can’t pay their bills. The court decides whether to discharge the debts, and those who owe are no longer legally required to pay them.
Bankruptcy laws were written to give people whose finances have collapsed, a chance to start over. Whether the collapse is a product of bad decisions or bad luck, lawmakers could see that in a capitalist economy, consumers and businesses who fail financially need a second chance.
And nearly all who file for bankruptcy get that chance.
Ed Flynn, of the American Bankruptcy Institute (ABI), did a study of PACER stats (public court records) from Oct. 1, 2018, through Sept. 30, 2019, and found that there were 488,506 Chapter 7 bankruptcy cases completed in that fiscal year. Of them, 94.3% were discharged, meaning the individual was no longer legally required to pay the debt.
Only 27,699 cases were dismissed, meaning the judge or court trustee felt like the individual had enough resources to pay his or her debts.
Individuals who used Chapter 13 bankruptcy, known as “wage earner’s bankruptcy,” were almost evenly split in their success. Slightly less than half of the 283,412 Chapter 13 cases completed were discharged (126,401) and 157,011 were dismissed, meaning the judge felt the person filing had enough assets to handle his or her debts.
Who Declares Bankruptcy
The individuals and business who file for bankruptcy have far more debts than money to cover them and don’t see that changing anytime soon. In 2019, bankruptcy filers owed $116 billion and had assets of $83.6 billion, almost 70% of that was real estate holdings, whose real value is debatable.
What is surprising is that people – not businesses – are the ones most often seeking help. They have taken on financial obligations like a mortgage, auto loan or student loan – or perhaps all three! – and don’t have the income to pay for it. There were 774,940 bankruptcy cases filed in 2019, and 97% of them (752,160) were filed by individuals.
Only 22,780 bankruptcy cases were filed by businesses in 2019.
Most of the people filing bankruptcy were not particularly wealthy. The median income for the 488,506 individuals who filed Chapter 7, was just $31,284. Chapter 13 filers were slightly better off with a median income of $41,532.
Part of understanding bankruptcy is knowing that, while bankruptcy is a chance to start over, it definitely affects your credit and future ability to use money. It may prevent or delay foreclosure on a home and repossession of a car, and it can also stop wage garnishment and other legal action creditors use to collect debts, but in the end, there is a price to pay.
When Should I Declare Bankruptcy?
There is no “perfect” time, but one rule of thumb to keep in mind is the length of time it will take to pay down your debts. When asking yourself the question “Should I file for bankruptcy?” think hard about whether it is going to take more than five years to pay your debts off. If the answer is yes, it might be time to declare bankruptcy.
The thinking behind this is that the bankruptcy code was set up to give people a second chance, not to punish them. If some combination of mortgage debt, credit card debt, medical bills and student loans has devastated you financially and you don’t see that changing, bankruptcy might be the best answer.
And if you don't qualify for bankruptcy, there is still hope.
Other possible debt-relief choices include a debt management program or debt settlement. Both of these typically need 3-5 years to reach a resolution, and neither one guarantees all your debts will be settled when you finish.
Bankruptcy carries some significant long-term penalties because it will remain on your credit report for 7-10 years, but there is a great mental and emotional lift when you’re given a fresh start and all your debts are eliminated.
Bankruptcy in the United States
Like the economy, bankruptcy filings in the U.S. rise and fall. In fact, the two are as connected as peanut butter and jelly.
Bankruptcy peaked with just more than two million filings in 2005. That is the same year the Bankruptcy Abuse Prevention and Consumer Protection Act was passed. That law was meant to stem the tide of consumers and businesses too eager to simply walk away from their debts.
The number of filings dropped 70% in 2006, to 617,660. But then the economy tanked and bankruptcy filings increased to 1.6 million in 2010. They retreated again as the economy improved and have gone down about 50% through 2019.
That may change significantly in 2020 as the economic impact of COVID-19 forces many individuals and small businesses to declare bankruptcy.
Filing for Bankruptcy
Filing for bankruptcy is a legal process that either reduces, restructures or eliminates your debts. Whether you get that opportunity is up to the bankruptcy court. You can file for bankruptcy on your own, or you can find a bankruptcy lawyer. Bankruptcy costs include attorney fees and filing fees. If you file on your own, you will still be responsible for filing fees.
If you cannot afford to hire an attorney, you may have options for free legal services. If you need help finding a lawyer or locating free legal services, check with the American Bar Association for resources and information.
Before you file, you must educate yourself on what happens when you file for bankruptcy. It’s not simply a matter of telling a judge “I’m broke!” and throwing yourself at the mercy of the court. There is a process – a sometimes confusing, sometimes complicated one – that individuals and businesses must follow.
The steps are:
- Compile financial records: List your debts, assets, income, expenses. This gives you, anyone helping you, and eventually the court, a better understanding of your situation.
- Get credit counseling within 180 days before filing: Bankruptcy counseling is required. It assures the court you have exhausted all other possibilities before filing for bankruptcy. The counselor must be from an approved provider listed on the U.S. Courts website. Most counseling agencies offer this service online or over the phone, and you receive a certificate of completion once it’s done that must be part of the paperwork you file. If you skip this step, your filing will be rejected.
- File the petition: If you haven’t hired a bankruptcy lawyer yet, this might be the time to do it. Legal counsel is not a requirement for individuals filing for bankruptcy, but you are taking a serious risk if represent yourself. Understanding federal and state bankruptcy laws, and knowing which ones apply to your case, is essential. Judges are not permitted to offer advice, and neither are court employees. There also are many forms to complete and some important differences between Chapter 7 and Chapter 13 that you should be aware of when making decisions. If you don’t know and follow the proper procedures and rules in court, it could affect the outcome of your bankruptcy case.
- Meet with creditors: When your petition is accepted, your case is assigned to a court trustee, who sets up a meeting with your creditors. You must attend, but the creditors do not have to. This is an opportunity for them to ask you or the court trustee questions about your case.
Types of Bankruptcy
There are several types of bankruptcy for which individuals or married couples can file, the most common being Chapter 7 and Chapter 13.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy is generally the best option for those with a low income and few assets. It is also the most popular form of bankruptcy, making up 63% of individual bankruptcy cases in 2019.
Chapter 7 bankruptcy is a chance to get a court judgment that releases you from responsibility for repaying debts and you also permitted to keep key assets that are considered “exempt” property. “Non-exempt property” will be sold to repay part of your debt.
By the end of the Chapter 7 bankruptcy process, the majority of your debts will be discharged and you will no longer have to repay them.
Property exemptions vary from state to state. You may choose to follow either state law or federal law, which may allow you to keep more possessions.
Examples of exempt property include your home, the car you use for work, equipment you use at work, Social Security checks, pensions, veteran’s benefits, welfare and retirement savings. These things can’t be sold or used to repay debt.
Non-exempt property includes things like cash, bank accounts, stock investments, coin or stamp collections, a second car or second home, etc. Non-exempt items will be liquidated – sold by a court-appointed bankruptcy trustee. Proceeds will be used to pay the trustee, cover administrative fees and, if money allows, repay your creditors as much as possible.
Chapter 7 bankruptcy stays on your credit report for 10 years. While it will have an immediate impact on your credit score, the score will improve over time as you rebuild your finances.
Those who file for Chapter 7 bankruptcy will be subject to the U.S. Bankruptcy Court’s Chapter 7 means test, which is used to weed out those who might be able to partially repay what they owe by restructuring their debt. The means test compares a debtor’s income for the previous six months to the median income (50% higher, 50% lower) in their state. If your income is less than the median income, you qualify for Chapter 7.
If it’s above the median, there is a second means test that may allow you to qualify for Chapter 7 filing. The second means test measures your income vs. essential expenses (rent/mortgage, food, clothing, medical expenses) to see how much disposable income you have. If your disposable income is low enough, you could qualify for Chapter 7.
However, if a person has enough money coming in to gradually pay down debts, the bankruptcy judge is unlikely to allow a Chapter 7 filing. The higher an applicant’s income is relative to debt, the less likely a Chapter 7 filing will be approved.
Chapter 13 Bankruptcy
Chapter 13 bankruptcies make up about 36% of non-business bankruptcy filings. A Chapter 13 bankruptcy involves repaying some of your debts in order to have the rest forgiven. This is an option for people who do not want to give up their property or do not qualify for Chapter 7 because their income is too high.
People can only file for bankruptcy under Chapter 13 if their debts do not exceed a certain amount. In 2020, an individual’s unsecured debt could not exceed $394,725 and secured debts had to be less than $1.184 million. The specific cutoff is reevaluated periodically, so check with a lawyer or credit counselor for the most up-to-date figures.
Under Chapter 13, you must design a three- to five-year repayment plan for your creditors. Once you successfully complete the plan, the remaining debts are erased.
However, most people do not successfully finish their plans. When this happens, debtors may then choose to pursue a Chapter 7 bankruptcy. If they don't, creditors can resume their attempts to collect the full balance owed.
Different Types of Bankruptcy
Chapter 9: This applies only to cities or towns. It protects municipalities from creditors while the city develops a plan for handling its debts. This typically happens when industries close and people leave to find work elsewhere. There were just four Chapter 9 filings in 2018. There were 20 Chapter 9 filings in 2012, the most since 1980. Detroit was among those filing in 2012 and is the largest city ever to file Chapter 9.
Chapter 11: This is designed for businesses. Chapter 11 is often referred to as “reorganization bankruptcy” because it gives businesses a chance to stay open while they restructure the debts and assets in order to pay back creditors. This is used primarily by large corporations like General Motors, Circuit City and United Airlines, but can be used by any size business, including partnerships and in some rare cases, individuals. Though the business continues to operate during bankruptcy proceedings, most of the decisions are made with permission from the courts. There were just 6,808 Chapter 11 filings in 2019.
Chapter 12: Chapter 12 applies to “family farms” and “family fishermen” and gives them a chance to propose a plan to repay all or part of their debts. The court has a strict definition of who qualifies, and it’s based on the person having regular annual income as a farmer or fisherman. Debts for individuals, partnerships or corporations filing for Chapter 12 can’t exceed $4.03 million for farmers and $1.87 million for fishermen. The repayment plan must be completed within five years, though allowances are made for the seasonal nature of farming and fishing.
Chapter 15: Chapter 15 applies to cross-border insolvency cases, in which the debtor has assets and debts both in the United States and in another country. There were 136 cases of Chapter 15 filed in 2019. This chapter was added to the bankruptcy code in 2005 as part of the Bankruptcy Abuse Prevention and Consumer Protection Act. Chapter 15 cases start as insolvency cases in a foreign country and make their way to the U.S. Courts to try and protect financially troubled businesses from going under. The U.S. courts limit their scope of power in the case to only the assets or persons that are in the United States.
Consequences of Bankruptcy
The overriding principle of bankruptcy is that it gives you a fresh start with your finances. Chapter 7 (known as liquidation), wipes away debt by selling non-exempt possessions that have some value. Chapter 13 (known as the wage earner’s plan) gives you an opportunity to develop a 3-5 year plan to repay all your debt and keep what you have.
Both equal a fresh start.
Yes, filing for bankruptcy impacts your credit score. Bankruptcy remains on your credit report for 7-10 years, depending upon which chapter of bankruptcy you file under. Chapter 7 (the most common) is on your credit report for 10 years, while a Chapter 13 filing (second most common) is there for seven years.
During this time, a bankruptcy discharge could prevent you from getting new lines of credit and may even cause problems when you apply for jobs.
If you are considering bankruptcy, your credit report and credit score probably are damaged already. Your credit report may improve, especially if you consistently pay your bills after declaring bankruptcy.
Still, because of the long-term effects of bankruptcy, some experts say you need at least $15,000 in debt for bankruptcy to be beneficial.
Where Bankruptcy Doesn't Help
Bankruptcy does not necessarily erase all financial responsibilities.
It does not discharge the following types of debts and obligations:
- Federal student loans
- Alimony and child support
- Debts that arise after bankruptcy is filed
- Some debts incurred in the six months before filing bankruptcy
- Loans obtained fraudulently
- Debts from personal injury while driving intoxicated
It also does not protect those who co-signed your debts. Your co-signer agreed to pay your loan if you didn't, or couldn't pay. When you declare bankruptcy, your co-signer still may be legally obligated to pay all or part of your loan.
Most people consider bankruptcy only after they pursue debt management, debt consolidation or debt settlement. These options can help you get your finances back on track and won't have a negative impact on your credit as much as a bankruptcy.
Debt management is a service offered by nonprofit credit counseling agencies to reduce the interest on credit card debt and come up with an affordable monthly payment to pay those off. Debt consolidation combines all your loans to help you make regular and timely payments on your debts. Debt settlement is a means of negotiating with your creditors to lower your balance. If successful, it directly reduces your debts.
To learn more about bankruptcy and other debt-relief options, seek advice from a local credit counselor or read the Federal Trade Commission's informational pages.
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