What Is Bankruptcy & How Does It Work?

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, partnerships, and businesses whose debts have become so overwhelming they don’t believe they can pay them.

The court decides whether to discharge the debts. A “discharge” means those who owe are no longer legally required to pay them. The court also could dismiss the case if it believes the person or business has enough assets to pay their bills.

Bankruptcy laws were written to give people an opportunity to start over when their finances collapsed. Whether the collapse is a product of bad decisions or bad luck, lawmakers could see that a second chance is a vital fallback in a capitalist economy.

The good news for anyone hesitant about this option is that nearly everyone who files for bankruptcy gets that second chance. The American Bankruptcy Institute says that 95.3% of people who file Chapter 7 bankruptcy are successful.

“Filing for bankruptcy is a big decision,” said Ashley Morgan of Ashley F. Morgan Law. PC in Herndon, Va.  “Some people say it should be your last option; I believe it should be something you learn about early, but not your first option.

“Bankruptcy can vary so much from situation to situation that you should know if it is a decent option for you before making any significant decision.”

Who Declares Bankruptcy?

Most individuals and businesses filing for bankruptcy have far more debts than money to cover them and don’t see that changing anytime soon.

On the other hand, bankruptcy can often be used as a financial planning tool when you do have enough money to repay debts but need to restructure the terms. This is often in cases when people need to repay mortgage arrears or taxes in a structured repayment plan.

What is surprising is that individuals – not businesses – are the ones most often filing for bankruptcy. They owe money for a mortgage, credit card debt, auto loan or student loan – perhaps all four! – and don’t have the income to pay it.

There were 413,616 bankruptcy cases filed in 2021. Only 14,347 were filed by businesses.

The other surprise is that most of the people filing bankruptcy were not wealthy. Median incomes for those filing Chapter 7 and Chapter 13 bankruptcies range from the low- $30,000s-to-low-$40,000s.

Part of understanding bankruptcy is knowing that, while it 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.

However, in the end, there is a price to pay, and you’ll pay it for 7-10 years. One cost is finding low-interest loans.

“(A bankruptcy ) makes it much more difficult to obtain lending at a reasonable rate of interest,” said David Reischer, bankruptcy attorney and CEO of LegalAdvice.com. “Lenders will typically offer low credit score subprime borrowers financing at interest rates that are double the national average for borrowers without a bankruptcy on their credit report.”

Bankruptcy in the United States

There were 413,616 bankruptcy filings in the calendar year 2021. According to statistics released by the Administrative Office of the U.S. Courts, that is a decrease of 24% over 2020. Business bankruptcy filings fell 33.7% from 21,655 to 14,347 during the same period.

Filings decreased across the board. Chapter 7, once again the most popular form of bankruptcy (69%) fell to 288,327 from 378,953 in 2020.

Chapter 13 counted 120,002 filings (29%), down from 156,377 the previous year. And Chapter 11 filings dropped from 8,333 to 4,836 in 2020.

“The decrease in filings in 2021 does not surprise me,” said Shawn Plummer, CEO of The Annuity Expert. “Since the pandemic we've seen student loan moratoriums, pauses on rent, higher unemployment benefits (including direct checks to citizens), and other financial aid measures that were as unprecedented as a global pandemic.

“Coupled with rock bottom interest rates, people have just had access to more funding than in the past. We may see bankruptcy rates rise this year, with the pressure inflation is putting on consumers.”

Ed Flynn, of the American Bankruptcy Institute (ABI), found that 94.9% of Chapter 7 filings in his 2020 study were successfully discharged. Only 21,677 cases of the 442,145 cases completed in 2020 were dismissed.

Individuals who used Chapter 13 bankruptcy, known as “wage earner’s bankruptcy,” didn’t have nearly as much success. In fact, of the 246,369 Chapter 13 cases completed in 2020, only 43.2% (106,476) were successfully discharged. The majority of cases – 139,893 – were dismissed and thus unsuccessful.

Like the economy, filings in the U.S. rise and fall as evidenced in the statistics on bankruptcy. In fact, they are like dance partners; where one goes, the other usually follows.

Total Number of Bankruptcy Filings by Year Graph

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, but then the Great Recession brought the economy to its knees and bankruptcy filings spiked to 1.6 million in 2010. They retreated again as the economy improved. For various reasons, bankruptcies in the early pandemic and again in 2021 decreased to numbers not seen since the 1980s.

When Should I Declare Bankruptcy?

When asking yourself “Should I file for bankruptcy?” think hard about whether you could realistically pay off your debts in less than five years. If the answer is no, 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 forever. If some combination of bad luck and bad choices has devastated you financially – and you don’t see that changing in the next five years – bankruptcy could be your best way out.

Even if you don’t qualify for bankruptcy, there is still hope for debt relief. Possible alternatives include a debt management program, a debt consolidation loan or debt settlement. Each one of those choices typically require 3-5 years to reach a resolution, and none of them guarantees all your debts will be settled when you finish.

The decision shouldn’t come down to how long Chapter 7 bankruptcy takes – the process itself is only 4-6 months. The thing you have to remember is that bankruptcy carries significant long-term penalties. It is stuck on your credit report for 7-10 years, which can make getting loans in the future very difficult.

The flip side of that is there is a great mental and emotional lift when all your debts are eliminated, and you’re given a fresh start.

“Sometimes waiting to declare bankruptcy can (help) a person or business manage their cash-flow in the short term which provides breathing room to survive over the medium or longer term without declaring bankruptcy,” said Reischer.

“A person or business should consider alternatives to bankruptcy such as looking for short term loans because declaring bankruptcy has significant and long-ranging effects. Sometimes it can be of benefit to wait until there really is no other option before actually declaring bankruptcy.

Why Declare Bankruptcy

If you’re filing for bankruptcy, you probably have tried many other options to avoid it, taking great effort to step out of what feels like financial quicksand. You’re likely as exhausted as your attempts and now recognize bankruptcy as a last resort.

Take heart. You’re not alone. Bankruptcy sometimes stems from unavoidable circumstances, or as a consequence of decisions that might not be in one’s total control.

  • Divorce: The legal costs alone can sink you financially, let alone the fallout of marriage dissolution.
  • A mountain of medical bills: According to a 2019 American Journal of Public Health report, 65% of bankruptcies were connected to medical expenses.
  • Poor financial decisions: Excessive use of credit cards, often because of other budgeting issues, is a leading reason for bankruptcy filings.
  • Job loss: If you don’t have a rainy-day fund – and many people don’t – job loss is a hole in the ceiling allowing debt to pour in.
  • Unexpected emergencies: Theft or loss of property, natural disasters, etc. When you’re already living on a razor’s edge, unexpected events can become financial catastrophes.

The millions of people who lost their jobs or businesses because of the coronavirus, have some hope because of bankruptcy. They still had bills to pay, and in many cases, no way to handle them. That’s what bankruptcy was meant to address. It’s not a bailout. It was created to give people a chance to get back on their feet financially and restore their peace of mind.

If your bills have grown to levels your income simply can’t handle, having your debts discharged through bankruptcy is a safe, legal and practical choice.

“You want to make sure you pick the right time to file,” said Morgan. “When you are facing something like a foreclosure or a garnishment, bankruptcy tends to be one of the only options to stop those types of collection activities. So, sometimes your hand is forced about when to file.

“Alternatively, if you are not at one of those extremes, it is important to review your situation. If you are in a situation where you are living on credit because your pay is not enough to make ends meet, it may not be the right time to file…Most people won't have access to more than a small credit card or two for a while after bankruptcy.”

How to File for Bankruptcy

You’ve decided to file for bankruptcy after exploring other options. You see filing for bankruptcy as the practical lifeline it can be if handled correctly.

It’s as important to know what not to do while filing bankruptcy as it is knowing the proper steps to have a successful bankruptcy filing.

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, which most experts regard as the prudent avenue to pursue.

Bankruptcy costs include attorney fees and filing fees. If you file on your own, you will still be responsible for filing fees. If you can’t afford to hire an attorney, you may have options for free legal services. If you need help finding an affordable bankruptcy 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 process – that individuals and businesses must follow.

The steps for filing bankruptcy are:

  • Compile financial records: List your debts, assets, income, and 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: You can’t file for bankruptcy until you’ve gone through a required bankruptcy counseling. 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 credit 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 you 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 or follow the proper procedures and rules in court, it could affect the outcome of your case. Without legal advice, you’re also running a risk that the bankruptcy trustee can seize and sell your property.
  • Meet with creditors: When your petition is accepted, your case is assigned to a bankruptcy trustee, who sets up a meeting with your creditors. You must attend but your creditors are not required to be there. This is an opportunity for them to ask you or the court trustee questions about your case.

» Learn More: Can You File Bankruptcy Online?

Types of Bankruptcy

There are six types of bankruptcy – Chapter 7, 9, 11, 12, 13 and 15 and. Chapter 7 and 13 are the most common types affecting individuals:

  • Chapter 7: A court appointed trustee may sell your assets and distribute the net proceeds to your creditors if you have assets not protected by an exemption.
  • Chapter 9: This is a proceeding that provides financially distressed municipalities – cities, townships, school districts, etc – with protection from creditors. It creates a plan to resolve the debt between the municipality and its creditors.
  • Chapter 11: Otherwise known as “reorganization bankruptcy,” Chapter 11 involves a restructuring of a debtor’s business affairs, debts, and assets. Companies have used Chapter 11 to restructure debt while remaining open for business.
  • Chapter 12: This is designed for financially distressed “family farmers” and “family fisherman.” The person in debt comes up with a plan to pay back creditors over three-to-five years.
  • Chapter 13: Chapter 13 enables individuals with regular paychecks to restructure their debt and repay some or all of their creditors. For that reason, it’s often referred to as “wage-earner’s bankruptcy.”
  • Chapter 15: Added to the code in 2005, Chapter 15 bankruptcy provides for cooperation between U.S. courts and foreign courts in the event foreign bankruptcy filings affect financial interests in the U.S.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy is generally the best (and most commonly used) option for those with a low income and few assets. Chapter 7 bankruptcy is a chance to get a court judgment that releases you from responsibility for repaying unsecured debts.

You also could be permitted to keep key assets considered “exempt” property. Non-exempt property will be sold to repay part of your debt. Just know that property exemptions vary from state to state.

By the end of a successful Chapter 7 filing, the majority (or all) of your debts will be discharged, meaning you will no longer have to repay them. Some debts that won’t be discharged in bankruptcy include alimony, child support, some types of unpaid taxes and some types of student loans.

Chapter 7 bankruptcy stays on your credit report for 10 years, but your score could improve over time as you rebuild your finances.  While some individuals may not qualify due to high income, others simply can’t afford Chapter 7 bankruptcy due to the fees and expenses.

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 3-5 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 succeed, creditors can resume their attempts to collect the full balance owed.

Chapter 11 Bankruptcy

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 to pay back creditors.

This is used primarily by large corporations like Hertz Rental Cars, JCPenney, Stein Mart and the XFL, all of whom filed Chapter 11 bankruptcy in 2020. This form 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 4,836 Chapter 11 filings in 2021.

Pros and Cons of Bankruptcy

Pros of Bankruptcy

  • The “automatic stay” provision in bankruptcy law means creditors cannot pursue action against you until the bankruptcy is discharged.
  • Harassing phone calls from creditors stop.
  • Provides a second chance to get your debt under control
  • Depending on the type of bankruptcy filed, you may not have to repay some or all of your debt.
  • A third-party court-appointed trustee will handle communication with your creditors and operate on your behalf.
  • You can keep some protected assets in Chapter 7. In Chapter 13, you typically keep assets while repaying debt.
  • Chapter 13 could allow you to prevent a foreclosure or auto repossession.
  • Filing for bankruptcy impacts your credit score but your score could rebound as you go through the process of settling , especially if you consistently pay your bills after declaring bankruptcy.

Cons of Bankruptcy

  • A bankruptcy discharge could prevent you from getting new lines of credit and may even cause problems when you apply for jobs.
  • Depending on the type of bankruptcy filed, you could lose valuable assets, including your car and home.
  • If federal student loans are the bulk of your debt, filing for bankruptcy won’t help. Only in rare cases is student debt dischargeable through a bankruptcy filing.
  • The cost of filing bankruptcy is typically between $1,000-$2,000 if you don’t qualify for legal aid.
  • Filing for bankruptcy stays on your credit report anywhere from 7-10 years.
  • If friends and families have co-signed loans, they could be liable for repaying debt in a bankruptcy filing.
  • You could have trouble gaining future credit, or offered higher interest credit, because you filed for bankruptcy.
  • Bankruptcies are public information and could come back to haunt you in future transactions or job interviews.
  • While bankruptcy can be a lifeline, it also typically does not address the source of your financial distress.
  • Because of the long-term consequences of bankruptcy, some experts say you need at least $15,000 in debt for bankruptcy to be beneficial.

Debts That Cannot Be Forgiven

Bankruptcy does not erase all financial responsibilities.

It does not discharge the following types of debts and obligations:

  • Federal student loans (unless you meet very strict criteria)
  • Court-ordered alimony and child support
  • Debts that arise after bankruptcy is filed
  • Some debts incurred in the six months before filing bankruptcy
  • Some taxes
  • 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.

Alternatives to Filing Bankruptcy

While bankruptcy can offer the best exit plan from crushing financial burdens, it’s not a one-size-fits-all remedy.

If you’re uncomfortable with the credit score collateral damage of filing bankruptcy or some of the messier fallout of filing for bankruptcy, you may want to consider the alternatives:.

  • Call your loan servicer and inquire about a forbearance or loan modification as an alternative to a bankruptcy filing.
  • Negotiate with creditors on your own. Some creditors (looking to cut their losses) might agree to a repayment schedule that reduces your debt.
  • A debt management plan, typically offered by non-profit credit counseling agencies, is one way to pay off high interest credit card debt and get your debt under control through financial planning and budgeting.
  • With debt consolidation a debtor can combine credit card debt with other debts in one monthly payment at a lower interest rate.
  • You might consider debt settlement – an agreement reached between a creditor and a borrower in which a reduced payment is accepted as full payment. Just know debt settlement carries credit score implications along the same lines as bankruptcy.

If these options aren’t possible, it may be worth it to look into low-cost bankruptcy options.

Before deciding, it would be wise to speak with legal counsel to determine your best option. To learn more about bankruptcy and other debt-relief options, seek advice from a nonprofit credit counselor or read the Federal Trade Commission’s informational pages.

Bankruptcy FAQs

You cannot apply for a new line of credit while your bankruptcy proceedings are ongoing without court approval. Depending on the type of bankruptcy filing, new credit card approval could take a few months or as long as 5-6 years.

Yes, but again patience is advisable. As is the case with credit cards, it depends on whether you filed Chapter 7 or Chapter 13 and whether the court dismissed or discharged your bankruptcy. A conventional loan could take as long as four years though there’s more leeway with government-backed loans.

Generally, there are no tax implications for individuals filing bankruptcy. But if you are expecting a tax refund, a bankruptcy trustee can keep that refund to pay creditors. In Chapter 7, that can happen only once, while in Chapter 13 that can happen every year of your repayment plan.

Not always. It could if the debts are held jointly but if one spouse files bankruptcy without the other, only the filing spouse’s debts are discharged.

Child support cannot be forgiven by filing Chapter 7 or Chapter 13 bankruptcy. Bankruptcy trustees appointed to your case have child support reporting requirements.

Employers cannot use a bankruptcy to terminate your employment. But bankruptcies could be taken into consideration by private employees in future job interviews.

Most retirement accounts, including your 401K, are protected from creditors when you file for bankruptcy.

About The Author

Bill Fay

Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it in 2012, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering the high finance world of college and professional sports for major publications, including the Associated Press, New York Times and Sports Illustrated. His interest in sports has waned some, but he is as passionate as ever about not reaching for his wallet. Bill can be reached at [email protected].

Article Reviewed By

Article Reviewed By

Patrick J Best - Bankruptcy Attorney

Patrick J. Best

Bankruptcy Attorney
Certified Financial Planner

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