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What Is Bankruptcy?
By Rachael Paul-Heinz MONEY RESEARCH COLLECTIVE
If the debts you’re responsible for outpace the savings you have and the future earnings you expect, you might consider declaring bankruptcy. Bankruptcy can be a protectionary measure for you, your family, your credit ratings and your current and future assets. However, the process can seem complex and frightening to someone unfamiliar with it.
Bankruptcy isn’t automatically an indicator of poor financial literacy, lapsed bills or irresponsible use of money. For some, bankruptcy is a reasonable and safe way to plan for their financial future.
Here’s more information about how it works, the options available and when bankruptcy may be the best move.
The ins and outs of bankruptcy
The bankruptcy process is designed to promote financial health and help people find legal and reasonable ways to pay off their debts — including medical bills, credit cards, personal and student loans, tax debts and more. It also allows people to start fresh and re-evaluate how they handle their finances. However, there are also some consequences that negatively impact your credit report.
How bankruptcy works
Bankruptcy is a legal process involving the debtor, the courts and the companies to which money is owed. Depending on the chapter of bankruptcy filed, the courts will either work with the debtor to develop a payment plan or take ownership of the debtor’s assets and begin the selling process for repayment.
Bankruptcy laws
Laws are in place to ensure the process and policies are fair and equitable, regardless of who is filing for bankruptcy and the amount of money they owe. Bankruptcy laws also control and monitor potential retaliation attempts from creditors.
One important bankruptcy law is the concept of an “automatic stay” to remove collections. If someone files for bankruptcy, creditors can no longer contact them for repayment. When someone completes their bankruptcy filing, they become protected under the law and cannot be threatened or approached by credit agencies.
Bankruptcy laws are complex and vary based on the type of bankruptcy you file. If you choose to file, your attorney can provide more information on the laws, policies and procedures that apply to you.
The six types of bankruptcy
There are six types of bankruptcy:
- Chapter 7: This is best for people with limited assets. A debtor’s property and assets are sold for cash to pay outstanding bills.
- Chapter 9: This option is geared towards public service organizations, including schools and municipalities.
- Chapter 12: This is geared towards people with variable or seasonable income, like gardeners or snow removal service providers. If a person in this position files for Chapter 12 bankruptcy, they will have a longer period (three to five years) to repay their debts.
- Chapter 13: Debtors in this category usually have a consistent income stream. Instead of selling property or assets, the debtor works with creditors to create and agree on a payment plan to resolve their debts.
- Chapter 15: This type is for foreign nationals who have filed for bankruptcy in their home countries and have assets or interests in the U.S.
How to file for bankruptcy
If you choose to file for bankruptcy, your first step is identifying the kind of bankruptcy you intend to file. Your options depend on if you’re filing as an individual or corporation and how you want to approach your debt.
Once you’ve selected your option, you must work with an attorney to file your bankruptcy documentation and begin the remediation process. Make sure to find an attorney experienced in the bankruptcy process. However, if you cannot afford attorney fees, you may be able to seek assistance from a public legal aid association or a pro bono legal consult.
As part of the bankruptcy process, you’ll be required to educate yourself on credit counseling. Your bankruptcy lawyer will help you access a credit counseling course that covers the fundamentals of responsible credit management.
Once you have completed this course, you will start the court proceedings relating to your bankruptcy filings. You must complete the necessary forms and filings to register with the court and pay any associated fees with the bankruptcy filing process.
You’ll also be required to meet with your creditors to establish payment timelines and protocols. This is when you learn how your debt will be forgiven — through a debt payment plan or by selling your assets. You’ll receive legal notification of your debt consolidation and bankruptcy payment plan.
Creating a debt management plan to avoid declaring bankruptcy
In some cases, bankruptcy may be the right choice. However, you may be able to prevent it. Before choosing to file for bankruptcy, you can work with a financial planner to develop a debt management plan that aligns with your income, debt levels and debt timeline.
If you feel you might be able to avoid declaring bankruptcy, you could:
- Organize your debt: Get a clear picture of what you owe and when it’s due. Figure out another option for credit repair, if available.
- Understand the penalties associated with your debt and prioritize your response: For example, you might want to pay off high-interest rate credit cards before other bills with lower rates. You should also pay the bills associated with your basic needs (rent, utilities, car payments) before more optional items (cable, gym memberships, etc.)
- Negotiate with debt collectors and develop an independent payment plan: You could also ask for some debt forgiveness if appropriate and acceptable. Most companies have policies for debt forgiveness or payment plans, which can make all the difference in your debt consolidation and organization efforts.
When bankruptcy might be the way to go
Bankruptcy often has a negative reputation, and those unfamiliar with it might think it’s a choice that leads only to negative results. However, filing for bankruptcy might be a smart move in some cases.
Bankruptcy might be a practical choice when:
- Your debts are insurmountable without legal intervention: Perhaps you have incurred overwhelming medical debt due to an illness or an injury or made a bad financial investment. Bankruptcy can help you recover from these kinds of setbacks and reset your financial future.
- You’ve tried unsuccessfully to negotiate with your creditors: Maybe you’ve spoken to your creditors, and they are unwilling to negotiate or develop a payment plan with you. Some organizations, including credit card and insurance companies, offer debt repayment plans. If yours doesn’t — or their plan is not attainable — bankruptcy might be a smart choice.
- You have future plans: You may be starting your career or have long-term financial goals you can’t achieve with debt hanging over your head. A temporary reset from a bankruptcy and a debt recovery plan can set you on a financially stable and sustainable long-term path. It can help you repair bad credit.
Bankruptcy FAQs
What are the benefits of filing for bankruptcy?
Filing for bankruptcy can benefit people or organizations struggling with uncontrollable debt. Potential benefits can include:
- Protection from creditors taking additional action against you: If you fail to pay your bills, creditors may file an individual lawsuit, freeze your bank accounts or credit cards or turn off your utilities. This can also allow you to remove charge-offs and hold on to the assets under lien, like your home, automobile or other necessities you owe money on.
- Debt consolidation or forgiveness: You may be eligible for debt consolidation or forgiveness as determined by the court handling your bankruptcy filing. This can provide significant relief by helping to make the amount you owe more reasonable and surmountable.
- Time to recover financially: A bankruptcy payment plan can help you organize how much you need to pay and when. It provides clarity and a path forward to help you re-evaluate your finances. In the long term, bankruptcy can improve your credit score.
What are the downsides of filing for bankruptcy?
While there are benefits to filing for bankruptcy, there are also downsides. You might want to reconsider filing for bankruptcy for a few reasons:
- There will be a significant negative impact on your credit report: A bankruptcy filing of any chapter will automatically be logged onto your publicly available credit report for up to 10 years. Credit reports are viewed and pulled in many cases, including employee background checks and applications for credit cards, loans and bank accounts. So a bankruptcy filing on your credit report could impact your future decisions and financial activity.
- Bankruptcy filing extends beyond your credit report: You might not be considered eligible for certain kinds of employment or be unable to rent a home. You might not even be able to open a bank account or purchase an insurance policy because a bankruptcy filing appears every time someone checks your credit report.
- Bankruptcy does not guarantee all debt is covered: Bankruptcy filings do not forgive things like student loans and tax-related debt. You will still be responsible for some types of debt not under the terms set by your bankruptcy filing.
How much does it cost to file for bankruptcy?
Despite being a debt mitigation strategy, filing for bankruptcy comes at a cost. There are court and filing fees associated with filing for bankruptcy with the U.S. courts. The cost can vary depending on the type of bankruptcy; the lowest fees are for Chapter 13 bankruptcy and the highest for Chapter 11.
In some cases, even these bankruptcy filing fees can be paid in installments as part of the overall bankruptcy proceedings. In other cases, the court might waive the fees if your situation merits it.
How long does a bankruptcy stay on your credit report?
It can take up to 10 years to remove a bankruptcy from your credit report. While it’s there, it significantly impacts your credit score and restricts your ability to take on additional debt. Fulfilling your requirements timely could remove your bankruptcy filing from your credit report more quickly.
How often can you file for bankruptcy?
There is no limit to the number of times you can file for bankruptcy, but there are limitations on the time periods between which you can file. The waiting periods exist regardless of if you’re filing the same bankruptcy chapter multiple times or different types of bankruptcy.
The following waiting periods apply:
- Eight years from your Chapter 7 bankruptcy filing if you want to file Chapter 7 bankruptcy again
- Four years from your Chapter 7 bankruptcy filing if you want to file Chapter 13 bankruptcy
- Two years from your Chapter 13 bankruptcy filing if you want to file Chapter 13 bankruptcy again
- Six years from your Chapter 13 bankruptcy filing if you want to file Chapter 7 bankruptcy
Filing times can also be impacted by the percentage of debt repaid, the amount to be repaid and when and if the courts dismiss the bankruptcy.
When in doubt, consult a bankruptcy attorney
This information is intended to be a learning resource but only covers some of the necessary knowledge for your situation. It’s always best to consult a bankruptcy attorney if you have additional questions about bankruptcy laws, processes, costs or caveats.