When you just can’t pay your debts and continue to survive, bankruptcy might be the only way out. However, this debt relief option is a perilous one, rife with scams and people ready to take advantage of your dire situation. Moreover, the legal landscape surrounding bankruptcy is often misunderstood, and legal help 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.
What is bankruptcy?
Bankruptcy is the process by which you can get rid of some debts or make payments on 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 U.S., named for the corresponding section of the U.S. Bankruptcy Code:
- Chapter 7: Liquidation for individuals or businesses; in exchange for getting rid of (discharging) most of your debt, you give up most of your assets. Note: 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. Note: Your debts must be under certain levels, and you must also have sufficient income to repay them.
- Chapter 15: For international cases.
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 cannot be seized in bankruptcy. What’s exempt varies from state to state and usually is based on the value of the asset in question. For example, if your state has a $5,000 exemption for vehicles and your car 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 usually student loans.
- What is a means test? Courts apply a test to potential Chapter 7 filers to make sure that high-income earners aren’t taking advantage of the system. If you pass the test, your income is low enough to qualify for Chapter 7. Generally, the means test works like this: If your income is less than your state’s 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|
|How it works||The vast majority of unsecured debts, such as credit cards, medical bills and personal loans, are forgiven. You must thoroughly document your finances and eligibility. You may give up some assets but likely won't have to.||You get court approval of a plan to repay both unsecured and secured debts, such as mortgage and car loans, in part or whole. You'll pay over three to five years and will retain your assets.|
|Requirements||• Must pass the means test if you have primarily consumer debts. |
• Cannot have filed for Chapter 7 in the past eight years or Chapter 13 in the past six.
|• Must have sufficient income.
• Unsecured debt cannot exceed $394,725. Secured debt cannot exceed $1,184,200.
• Must be current on tax filings.
• Cannot have filed for Chapter 13 in the past two years or Chapter 7 in the past four years.
|Does it apply to every type of unsecured debt?||No, you must still pay child support and debts you owe the government, such as taxes. The court is highly unlikely to forgive student loan debt.||You'll have to repay some or all of your secured and unsecured debts over three to five years.|
|Can your house be seized?||If the equity in your house exceeds exemption levels for your state, it may be sold. Otherwise you keep it.||Not if you stay current on mortgage payments.|
|Can your car be seized?||If the equity in your car exceeds the exemption level for your state, it may be sold. Otherwise you keep it.||Not if you stay current on the payment plan.|
|How long does it stay on your credit reports?||Up to 10 years.||Up to 10 years, likely closer to seven.|
How to file for bankruptcy
The process of bankruptcy is actually fairly simple — but, as always, the devil is in the reams-of-paper details. Once you find the right attorney for your situation, here are the steps in filing for bankruptcy.
|Chapter 7||chapter 13|
|Gather information: Speak to a lawyer about the best way to file. Bring documentation of your expenses and income, such as pay stubs, mortgage statement and car payment, to have as informed a conversation as possible.
While attorney fees may be high, the cost of improperly filing can be even higher: Your case may be thrown out. Explore strategies for affording a lawyer or finding pro bono (no-charge) representation.
|Begin counseling: Receive pre-bankruptcy credit counseling within 180 days before filing for bankruptcy. You can do this online or by phone with a U.S. Courts approved credit counseling agency. This shouldn’t cost more than $50.|
|Collaborate on paperwork: Work with your lawyer to meet deadlines and fill out paperwork accurately and completely. This will include a list of your assets and liabilities, your budget and recent financial history.
For a Chapter 13 bankruptcy, you'll also file a proposed payment plan at this time.
|File: To finish filing your petition, you’ll also have to pay a filing fee ($335 for Chapter 7, $310 for Chapter 13) unless you get a fee waiver.
Filing the petition will trigger what’s called an automatic stay, which means that most of your creditors won’t be able to pursue lawsuits, garnish your wages or contact you about your debts.
Note: Debtors in a Chapter 13 case must make their first payment within 30 days of filing.
|Attend creditor meeting: At this meeting, a trustee will establish the accuracy of the papers you filed and may ask for further information about assets that might be nonexempt. |
In most cases, the trustee will file the report and close the case shortly thereafter. If there are outstanding questions, the meeting may be postponed for you to fill in holes in your paperwork.
|Attend creditor meeting. The trustee will verify the value of your assets and that you can make the payments you propose.
If satisfied, the trustee will recommend confirmation of your plan. If there are objections, the parties will try to resolve them.
|Complete counseling: You must complete a pre-discharge credit counseling course before your case closes. This usually costs $50-$100; you can find accredited providers on the Department of Justice website.|
Should I file Chapter 7 or Chapter 13?
- Do you pass the means test?
- Has it been at least eight years since the last time you filed for Chapter 7 bankruptcy or four years since you filed for Chapter 13?
If you answered “yes” to both of those questions, you’re probably eligible for Chapter 7.
Now, 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 13. 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 many assets. Many Chapter 7 filers have modest cars and not much income. 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 three to five years.
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 (for a while), and might take away some of your assets. Instead of discharging your debts, you can consider:
- Debt management: You or a credit counselor contacts each of your lenders to see if they will cut your interest rate, drop some fees or let you stretch out your repayment timeline.
- 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.
Watch out for bankruptcy scams
Unfortunately, there are many people eager to take advantage of someone in financial distress. Watch 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.
This article updated May 20, 2016. It originally published Aug. 2, 2013.