When you just can’t pay your debts and continue to survive, bankruptcy might be the only way out. However, the road to discharging your debt is a perilous one, rife with scams and people ready to take advantage of your dire situation. Moreover, the legal landscape surrounding bankruptcy is a labyrinth, and legal aid isn’t cheap. The entire process runs several hundred dollars in fees. We’ll break down the basics of bankruptcy – who should file, how to file and what to watch out for – and help you get back on track to financial security. In this article:
What is bankruptcy?
Bankruptcy is the process by which you can get rid of or make payments for some of your debts under the protection of a federal court. You, your creditors and a judge work out an arrangement where the creditor might forgive some of your debt or give you more favorable terms, and you might have to give up some of your assets. Bankruptcy tanks your credit, so you’ll find it hard to borrow money for many years. There are two categories of bankruptcy:
- Liquidation, where the creditor seizes all of the debtor’s non-exempt assets and forgives almost all of the debt
- Reorganization, where the debtor and creditor work out a new payment plan
There are six types (called chapters) of bankruptcy in the US, named for the corresponding section of the US Bankruptcy Code:
- Chapter 7: Liquidation for individuals or businesses; in exchange for discharging most of your debt, you give up most of your assets
- You must pass a means test in order to file Chapter 7.
- Chapter 9: Municipal bankruptcy, for cities
- Chapter 11: Reorganization for businesses; allows companies to function while making debt repayment plans
- Chapter 12: Reorganization for family farmers and fishermen; available only in limited cases but provides higher debt ceilings and better exemptions than Chapter 13
- Chapter 13: Reorganization for individuals with a source of income; also known as Wage Earner Bankruptcy
- Your debts must be under certain levels to file for Chapter 13; you must also have sufficient income to repay them.
- Chapter 15: For international cases
The only two that you’ll probably need to worry about are Chapter 7 and Chapter 13. Of the two, Chapter 7 is the most common, quickest, and simplest.
Chapter 7 vs. Chapter 13
The main types of consumer bankruptcy are Chapter 7 (liquidation) and Chapter 13 (reorganization). While Chapter 13 is often preferable to Chapter 7, it’s harder to qualify for. We’ll break down the requirements, pros and cons of each. First, a few definitions:
- What is exempt property? Exempt property, which cannot be seized in bankruptcy, varies from state to state. This is usually based on the value of the asset in question. For example, if your state has a $5,000 exemption for vehicles and yours is worth $2,000, it can’t be seized. Other types of assets, like child support payments, veteran’s benefits and victim compensation, can’t be seized no matter how valuable they are.
- The federal government has a baseline set of exemptions, but most states require you to use their own. Check out this guide to exemptions in your state.
- What are exempt debts? Some debts can’t be discharged, even in bankruptcy. These include certain taxes, debts you didn’t list on your bankruptcy filing, debts owed to the government, child support, and most student loans.
- What is a means test? Courts apply a means test to potential Chapter 7 filers to make sure that high-income earners aren’t taking advantage of the system. If you pass the means test, your income is low enough to qualify for Chapter 7. Generally, the means test works like this: If your income is less than the state median, you qualify. If your income is higher than the state median, the courts look at your disposable income (your monthly income minus necessary expenses like food and shelter). Disposable incomes below a certain level might still qualify for Chapter 7. The specific levels and income calculations vary by state.
|Chapter 7||Chapter 13|
|Percent of bankruptcy filings||71%||29%|
|How it works||A trustee is appointed to seize your non-exempt assets and turn them over to your creditors. You retain only your exempt assets, but are forgiven most of your debts.||A judge approves a payment plan where you pay off your debts over a period of 3-5 years. You pay almost all the amount owed, but you get to keep your assets.|
|Effect on non-exempt debt||Mostly forgiven||Almost all debts will still need to be paid, but liability ends with the payment plan|
|Effect on exempt debt (student loans, child support, taxes, etc)||Still need to be paid|
|Can your house be seized?||Not if you stay current on mortgage payments|
|Can your car be seized?||Potentially||Not if you keep up with the payment plan|
|Can your non-exempt assets be seized?||Yes, all of your non-exempt assets are vulnerable||Not if you keep up with the payment plan|
|When can you file again?||Chapter 7: 8 years Chapter 13: 4 years||Chapter 7: 6 years Chapter 13: 2 years|
|Requirements||Must pass “means test:” your income usually has to be less than the state median||Must have sufficient income to repay debts Unsecured debt (such as credit card or medical debt) must not exceed $383,175 Secured debt (such as a mortgage or car loan) must not exceed $1,149,525 Must be current on tax filings|
|Stays on credit report for||10 years||7-10 years|
How to file for bankruptcy
The process for bankruptcy is actually fairly simple – as always, the devil is in the reams-of-paper details. Here are the steps in filing for bankruptcy.
|Chapter 7||Chapter 13|
|Speak to a lawyer about the best way to go about filing. While the fees may be high, the cost of improperly filing can be even higher. If you can’t afford an attorney, check with the American Bar Association in your area for pro bono representation. The lawyer will help you decide whether you should file Chapter 7 or 13.|
|Receive credit counseling within 180 days before filing for bankruptcy. You can complete pre-bankruptcy credit counseling online or by phone by a US Courts approved provider. This shouldn’t cost more than $50.|
|Complete the rest of the bankruptcy filing paperwork. You can do this online at the US Courts website. This will include a schedule of your debts and assets, current income and expenses, contracts and leases.|
|To finish filing your petition, you’ll also have to pay a filing fee ($299 for Chapter 7, $155 for Chapter 13) unless you get a fee waiver. Once the petition is filed, most of your creditors won’t be able to pursue lawsuits, garnish your wages or contact you about your debts.|
|Attend the meeting of creditors, where a trustee will negotiate with your creditors to discharge your debt in exchange for liquidating some of your assets. Usually, you won’t meet with a judge during Chapter 7 bankruptcy.||File a plan of repayment that will pay off your debts over 3-5 years. This must be filed no more than 15 days after you file your petition.|
|Attend the meeting of creditors, where your creditors will talk to you about your assets, debts and financial situation.|
|Attend a confirmation hearing in court, where a judge will approve or reject your plan. Creditors are allowed to object to the confirmation.|
|You’ll begin making payments within 30 days of the plan’s approval. If you can’t keep up with your payments, you may choose to file Chapter 7 later on.|
|You must complete a debtor education course within 60 days of your first creditor meeting (for Chapter 7) or before making your last plan payment or before filing a motion to discharge your debts (Chapter 13). This usually costs $50-$100; you can find accredited providers on the Department of Justice website.|
Should I file Chapter 7 or Chapter 13?
First off, you need to figure out if you’re eligible for Chapter 7 bankruptcy:
- Do you pass the means test?
- Has it been at least 8 years since the last time you filed for Chapter 7 bankruptcy, or 4 years since you filed for Chapter 13?
If you answered “yes” to both of those questions, you’re probably eligible for Chapter 7. Now, to find out if you’re eligible for Chapter 13:
- Do you have sufficient income to repay your debts?
- Is your unsecured debt (such as credit card debt) less than $383,175?
- Is your secured debt (such as a home or car loan) less than $1,149,525?
- Are you current on your federal and state tax filings?
If you answered “yes” to all four of those questions, you’re probably eligible for Chapter 7. If you find that you’re eligible for both Chapter 7 and 13, you’ll have to make a decision. Chapter 7 is better if:
- You don’t have that many assets to begin with. Many Chapter 7 filers have modest cars and not much by way of income, so if most of your possessions fall within the exemption limits, you don’t have to worry about your assets being seized.
- You don’t think you’ll be able to pay off your debts in a 3-5 year timeframe.
Chapter 13 is better if:
- You’re behind on your mortgage or car payments and want to make them up over time.
- Most of your debts are student loans, child support, or other debts that can’t be discharged even under Chapter 7.
- You have non-exempt assets that you want to keep, such as a nicer car or jewelry.
- You have a co-signer on the indebted account. If you have a co-signer and file Chapter 7, creditors are free to go after your co-signer even though you’re protected. If you file Chapter 13, you can arrange to pay off the co-signed debt in your repayment plan.
Alternatives to bankruptcy
Bankruptcy is the nuclear option for debt – it tanks your credit score, and might take away some of your assets. Instead of discharging your debts, you can consider:
- Debt settlement: You or a credit counselor contacts each of your lenders to try to negotiate a way out. You’ll pay a lump sum that’s less than the amount you owe, and the creditor will consider the debt repaid.
- Debt consolidation: You take out a new loan (presumably at a lower interest rate) and use the money from the loan to pay off all your other debts. You then make your monthly debt payments toward the new loan. For example, you can take out a home equity line of credit to pay off your credit cards. Since the debt is secured by your house, you’ll probably have a lower interest rate than your unsecured credit card debts.
Watch out for bankruptcy scams
Unfortunately, there are many people eager to take advantage of someone in financial distress. Keep an eye out for anyone who:
- Asks you to pay a fee before receiving any services
- Promises to magically repair your credit
- Tells you to make your debt payments to their company rather than your creditors, without your creditors’ explicit consent
- Promises to wipe out your debt without you having to declare bankruptcy or pay a fee
- Says you need professional help to contact creditors
- Tells you to stop communicating with your creditors
- Tells you you’re “eligible for a government program” to help relieve your debt – only the government agency in question can determine your eligibility