Bankruptcy has a bad reputation. For many people it’s synonymous with financial failure. It still has a place in the spectrum of debt relief options. If your debt situation is impossibly tangled, personal bankruptcy might be the only practical way out. It’s something to avoid when possible, but not at all costs.
Remember that bankruptcy is not a punishment. It provides a fresh start to people with more debt than they can possibly afford to pay. You’ll pay a price for that fresh start, but if you’re out of debt relief options it can still be worth it. If you are considering filing for bankruptcy, here’s what you need to know.
What Is Bankruptcy?
Bankruptcy is a legal process governed by federal law and implemented by federal bankruptcy courts. It can clear most forms of unsecured debt while providing creditors a measure of repayment.
Two types of bankruptcy are commonly used by individuals. They have several features in common:
- Filing triggers an automatic stay against creditors, which means that they can no longer legally seek collection against you.
- The process involves financial education, which can prevent the mistakes that led you to bankruptcy in the future.
- At the end of the process, the court will discharge eligible credit accounts. That means you’ll typically pay far less than your full balances. In many cases a debt will be completely discharged, which means you are no longer responsible for paying it.
Bankruptcy can’t erase every type of debt. It won’t help you with your secured debts: if you have a mortgage or a car loan the lenders can still seize your collateral. Student loans, alimony, child support, and tax debts will usually not be discharged in bankruptcy.
How to File for Personal Bankruptcy
Filing for bankruptcy is a complex legal process. Standing up and shouting “I declare bankruptcy” like Michael Scott in The Office won’t be enough.
Bankruptcy courts are run by the US Government, and the requirements and costs are consistent across the country. You will file with the Bankruptcy Court that has jurisdiction in your area.
Before filing for bankruptcy you will have to gather documents to verify your financial position.
Once you’re ready to file, you’ll go through these steps.
- Pay a filing fee
- Determine which type of bankruptcy you will use
- Take mandatory credit counseling courses
- Complete and file complex legal forms with the court
- Make a full and accurate disclosure of your income, assets, debts, and living expenses
- Meet with a bankruptcy trustee and your creditors
Most people who go through the bankruptcy process retain a bankruptcy lawyer. A lawyer will represent you, guide you through the process, and answer your questions.
Many bankruptcy attorneys offer free initial sessions that will help you decide whether bankruptcy is right for you and what type of bankruptcy you will file. Bankruptcy is a complex topic and professional assistance will help you assess the advantages and disadvantages.
Types of Personal Bankruptcy
There are six different types of bankruptcy, covering individuals, businesses, corporations, municipalities, and other entities. Each type is referred to by its chapter in the Bankruptcy Code.
Most individual bankruptcies fall into two Chapters.
Chapter 7 Bankruptcy
Chapter 7 Bankruptcy is the most common form of personal bankruptcy. It’s known as liquidation bankruptcy because it empowers a bankruptcy trustee to sell off your non-exempt assets. The trustee will use the sale proceeds to pay your creditors.
Some property is exempt from this sale. Generally, you’ll be able to keep the assets you need to live. That may include your house and car, clothing, and retirement accounts. Many Chapter 7 cases are “no asset” cases. That means there’s nothing with enough value to sell. In these cases debts are often discharged with no payment at all.
To qualify for Chapter 7 bankruptcy you’ll have to pass a means test. There are two ways to do this:
- Your gross household income is below the state median.
- You fail option one, but your disposable income isn’t enough to meaningfully pay back your debts.
The second option is significantly more complicated. Either way, you have to demonstrate to the court that you’re not capable of repaying your creditors. If you do not pass either test you will have to file for Chapter 13 bankruptcy.
The Chapter 7 bankruptcy process normally takes four to six months. If you have few or no assets and your creditors do not dispute your bankruptcy it may take less time. Your unsecured debts will probably be discharged at the end of the process. You will no longer be responsible for paying them.
Chapter 13 Bankruptcy
Chapter 13 bankruptcy is for people who make too much money for Chapter 7 or want to protect their assets from liquidation. Instead of selling off your possessions to pay creditors, Chapter 13 creates a strict but affordable repayment plan. Chapter 13 bankruptcy is often referred to as reorganization bankruptcy.
You will have to provide the court with accurate and detailed information on your assets, income, expenses, and debts. The court will appoint a trustee to review your case, negotiate with your creditors, and design a repayment plan.
The repayment plan will last from three to five years, depending on your income, expenses, and debts. At the end of the plan, the court may discharge your remaining balances if you have faithfully complied with the plan. If you fail to comply the bankruptcy may be dismissed. You will be responsible for your debts again. Creditors can resume collection efforts.
Chapter 13 is usually the best option for people who have:
- Valuable non-exempt properties that might be sold under Chapter 7
- A steady income, especially one that’s too large to qualify for Chapter 7
Chapter 13 bankruptcy doesn’t include a means test. To qualify, you will have to hold less than $394,725 in unsecured debt and less than $1,184,200 in secured debt. These limits are adjusted frequently to keep up with inflation.
Because you will be paying off most of your debts, Chapter 13 bankruptcy has less impact on your credit than Chapter 7 bankruptcy. Chapter 13 will stay on your credit report for seven years and costs only $310 to file.
Who Should Consider Filing For Bankruptcy?
People who declare bankruptcy are usually under serious financial stress. That can be caused by a sudden job loss, medical bills, or an unexpected divorce. It can also be caused by excessive spending and poor financial management. A combination of these situations is often enough to push people over the edge.
If you aren’t facing any unusual financial obstacles, your debt problems are likely due to poor financial habits or a lack of education. In that case, you might be able to make do with a less extreme form of debt relief.
Make sure you explore all of your other options before you start to consider bankruptcy. Try to refinance and lower your interest rates, consolidate your outstanding loans, and work with a credit counselor, even if you don’t think those will be enough. Give them an honest try before you declare bankruptcy. Bankruptcy has significant consequences and it should be considered a last resort.
As a general rule, you should consider bankruptcy if it would take more than three to five years to pay off your debts even if you devote all resources beyond bare survival to debt payment. If you’re not sure, consult a credit counselor or a bankruptcy attorney. Many bankruptcy attorneys offer a free initial consultation to help you decide whether to pursue bankruptcy.
How Much Does Bankruptcy Cost?
Bankruptcy involves two primary costs. The first is the fees. You will have to pay $338 to file a Chapter 7 petition and $313 to file a Chapter 13 petition. You may be able to pay these fees in installments. If your income is below 150% of the poverty line in your area the court may waive the filing fee. Credit counseling and debtor education classes also require fees, often between $15 and $35. Some providers may offer free courses for financially distressed individuals.
The largest cost of filing for bankruptcy is hiring a lawyer. The American Bankruptcy Institute says that average legal costs are around $1072 for a Chapter 7 bankruptcy with assets. If you file for a Chapter 13 bankruptcy the average cost is $2564. Costs may be lower if you have no assets. They may be higher if your bankruptcy is complex or if a creditor contests it. More experienced lawyers may charge higher fees. Legal costs in urban areas are often higher than costs in rural areas.
It is possible to file for bankruptcy without a lawyer. It is difficult and risky, and most experts advise against it. Bankruptcy is complicated, and only specialized bankruptcy lawyers will deal with it. If you file with no lawyer at all you could lose assets that could have been protected or even see your case dismissed.
Legal help is often expensive, and most people who file for bankruptcy have limited cash flow. If you can’t afford a lawyer, you might be able to get help from a local legal aid society or a pro bono attorney. Failing that, look for a lawyer who will allow you to pay them after your case is closed. Many bankruptcy lawyers offer flexible repayment plans.
The Consequences of Personal Bankruptcy
Bankruptcy has long-lasting consequences. Most notably, it will have a substantial negative impact on your ability to qualify for new credit.
While it’s impossible to calculate exactly how much your credit score will decrease, the drop will be dramatic. Even if failed debt-relief efforts and missed payments have already hammered your credit, you’ll still see a significant drop.
Having a bankruptcy on your credit report can also make applying for a new job or leasing a residence more difficult. That can make finding housing a challenge since a mortgage will be out of the question for a while.
You may also lose valuable property to pay off your creditors if you file with Chapter 7. If you file under Chapter 13, you’ll have to adhere to a rigid payment schedule for several years.
Bankruptcy Is Not The End
While there are significant repercussions to filing for bankruptcy, you will be able to recover eventually. It’s not a financial death sentence. You can improve your credit score over the next few years with responsible behavior.
Don’t let the fear of embarrassment lock you into a never-ending debt cycle either. Over 700,000 people filed for personal bankruptcy in the twelve months ending in March 2020. If you need to declare bankruptcy, you’re not alone.
The most important part of recovering from the process is avoiding the problems that caused you to file in the first place. Learn to build a budget, live within your means, and use credit responsibly.
Once you declare bankruptcy, your access to credit will be limited. Try not to see that as a punishment, but rather protection from overextending yourself again. With the proper outlook, patience, and discipline, bankruptcy can be the beginning of a more prosperous phase in your financial journey.
Do you have any questions about personal bankruptcy? Let us know in the comments section below!