In 2017, there were 789,020 bankruptcy filings in the U.S., and 97% of those were personal (non-business). While the number of filings has decreased since 2013, people are still facing overwhelming debts that they can’t repay.
If your situation has reached the point of no return, filing bankruptcy may be the best way to start over. But there are some things you should understand first.
In this ultimate guide to bankruptcy, find everything you should know before filing, including:
- How bankruptcy works.
- The types of bankruptcy.
- The costs.
- Alternatives to consider.
Let’s get started!
Understanding bankruptcy: How bankruptcies work
The word bankruptcy is derived from the Italian phrase “banca rotta,” which means broken bank.
When a U.S. citizen or business can’t repay their debts, they can file for bankruptcy with the federal court to discharge their qualifying obligations.
It’s important to note, filing bankruptcy is not an easy or painless process and does have some serious consequences. For one, you have to pay filing fees and administrative costs (and often attorneys fees).
Here’s a look at the average costs for filing:
Further, a bankruptcy stays on your record for seven to 10 years. It can make it hard to qualify for credit, get a job, get good rates on insurance, etc.
It should be a last resort when all other avenues have been exhausted.
Who pays for bankruptcies?
The debtor pays to file bankruptcy and also must pay as much as possible to his or her creditors through selling their assets or a payment plan. Any qualifying debt that can’t be paid is “discharged” and chalked up as a loss for the creditor.
However, the creditor can often take a tax deduction for the bad debt. Further, creditors factor the risk of default into their interest rates to help them cover their losses.
Types of bankruptcy
More than one kind of bankruptcy exists. Here are the most common types for individual filers.
Chapter 7 bankruptcy (liquidation of assets)
Chapter 7 bankruptcy is often called a “no-asset” or “liquidation” bankruptcy. It involves a court-appointed trustee being assigned to the case to sell the debtor’s non-exempt property and repay as much of their debt as possible.
In many cases, debtors don’t have any non-exempt assets to sell, so the trustee files a no-asset report, and the creditors don’t receive anything. If assets are sold, and debts remain after the liquidation, those that qualify will be discharged.
What property is exempt?
Exemptions allow bankruptcy petitioners to keep a minimum amount of money and property so they can continue to support themselves with the bare necessities.
For example, in California, exemptions include real or personal property used as a residence up to $26,800, motor vehicles up to $5,350, personal injury recoveries up to $26,800, and many more.
While the Federal government has authority over bankruptcies and has exemption laws in place, states fought for the right to regulate exemptions, and many now have their own.
Filers will have to look up the regulations and choose whether to opt for those set by the state or the federal government.
What kind of debt is dischargeable in a Chapter 7 Bankruptcy?
Debt that qualifies for a Chapter 7 Bankruptcy must be incurred before the date you filed your petition and can’t be tied to any fraud or misconduct.
Further, some debts are not dischargeable such as secured loans, most tax bills, child support you owe, alimony you owe, debts as a result of injuring someone while driving under the influence, and student loans.
Unsecured debts such as those from credit cards, personal loans, medical bills, utility bills, past due rent, etc. will qualify for discharge.
What happens to secured loans?
Chapter 7 Bankruptcy does not remove liens, so if you have a mortgage or car loan and stop making payments, the lien holder can seize your property. However, bankruptcy can discharge repossession deficiency balances.
Are there eligibility requirements for Chapter 7 Bankruptcy?
To qualify for Chapter 7 Bankruptcy, your monthly income over the six months before your filing date must be less than the median income for a household of your size in your state.
Additionally, you must pass the “means test,” which requires your disposable income (after deducting certain expenses and monthly payments that would be required in chapter 13) to be under certain limits. Some exceptions apply.
If you don’t qualify, you will have to file Chapter 13.
In some cases, Chapter 7 Bankruptcy can be a smart option, but it’s not a great fit for everyone. Here are some things you should consider before you file. Compare the pros and cons.
- Eliminate most consumer debt (credit card and unsecured).
- Stop creditor and harassment activities.
- Keep some assets due to exemptions.
- Begin rebuilding sooner than with Chapter 13 Bankruptcy.
- Only takes three to six months.
- Must meet eligibility requirements.
- Must pay upfront to file.
- Best to hire an attorney, which costs more.
- Stays on your credit report for 10 years.
- Non-exempt assets may be liquidated.
- Often can’t eliminate student loans, secured debt, alimony, child support, tax debt, etc.
- Bankruptcy will be on public record.
- Must complete credit counseling with an approved credit counseling agency.
Chapter 13 Bankruptcy (individual debt adjustment)
Chapter 13 Bankruptcy involves the filer submitting a repayment plan to the court, which usually lasts three to five years.
Often, the plan requires the full repayment of certain debts (alimony, child support, taxes, secured debt, etc.), and using any leftover disposable income to make payments on unsecured debts.
Although this option often takes longer and can cost more, it allows you to keep some of the property you’d lose when filing Chapter 7 Bankruptcy. When the payment plan is complete, all eligible debts can be discharged.
In some cases, Chapter 13 Bankruptcy can be a smart option, but it’s not a great fit for everyone. Here are some things you should consider before you file. Compare the pros and cons.
- Gets removed from your credit report sooner than a Chapter 7 Bankruptcy.
- Enables you to keep your assets.
- Back up options are available if you are unable to complete the repayment plan.
- Exemptions can lower your required payment amount.
- Can help those who don’t qualify for Chapter 7 Bankruptcy because their income is too high.
- Is removed from your credit report three years sooner than a Chapter 7 Bankruptcy.
- Stays on your credit for seven years.
- Have to pay to file.
- Usually need to hire an attorney, which adds to the costs.
- Pay more than you would with a Chapter 7 Bankruptcy.
- It takes three to five years to complete.
- Monthly payment amounts in a Chapter 13 filing are generally comparable to or less favorable than those found with debt settlement program payments.
In addition to Chapter 7 and Chapter 13, four other less common types of bankruptcy exist as well. These include:
- Chapter 9 Bankruptcy: Allows municipalities (school districts, counties, cities, etc.) to reorder their debt and create a strategy for reimbursement.
- Chapter 11 Bankruptcy: Open to businesses and individuals but primarily for businesses that exceed the limits of Chapter 13.
- Chapter 12 Bankruptcy: Chapter 12 is for family farmers or fisherman who meet the conditions.
- Chapter 15 Bankruptcy: Chapter 15 is for foreign debtors (or related parties) that file for bankruptcy in another country and need access to the US Bankruptcy Courts.
“Chapter 20 Bankruptcy”
In some circumstances, debtors may benefit from pulling off a Chapter 20 Bankruptcy. Chapter 20 is an informal term used when debtors file for Chapter 7 Bankruptcy and immediately after file for a Chapter 13 Bankruptcy.
This strategy makes sense when you have large debts that can’t be discharged in a bankruptcy, such as IRS tax debt, and large amounts of dischargeable debt, such as credit cards and medical bills. Chapter 7 takes care of the unsecured debts while the protections of Chapter 13 Bankruptcy allows you to qualify for affordable payments on the non-dischargeable debts without having to worry about creditors calling.
The majority of Americans will be choosing between Chapter 7 and Chapter 13 when opting to file bankruptcy.
Alternatives to bankruptcy
What else can you do besides file bankruptcy?
Debt settlement is another option. It involves an agreement with creditors in which you pay less for the debt than you owe. This option is usually only available on unsecured debts, and creditors won’t settle if they think you can pay.
Being so, you typically have to be behind on payments for this to work. When you hire a debt settlement agency, they will have you stop paying your creditors and will instead put your payments into a savings account.
When the amount is large enough to make a lump-sum offer, they will contact the creditors and attempt to come to an agreement. If the creditor agrees, the amount is paid from the savings and the debt is settled.
Note, you may have to pay taxes on forgiven debt.
The downside? When you stop making payments, you will rack up fees and interest, and your credit report will reflect the missed payments which will cause your score to drop.
If you settle the debt, the debt settlement company will charge you a fee for its services. In cases where creditors don’t accept a settlement, you could end with a larger debt and hurt your credit score for no reason.
Personal credit cards can offer a lot of value to consumers, but they’re not a great fit for everyone. Here are some things you should consider about credit cards before you apply for one. Compare the pros and cons to make a better decision.
- Not on public record.
- Settle your debts for less than what you owe.
- Fees and interest accrue while you are saving up to make a lump sum offer.
- Missing payments and not paying the full amount will hurt your credit.
- Have to pay debt settlement company fees.
- Lenders may refuse to settle.
- The IRS may consider forgiven debt as taxable income.
- Must negotiate with each lender individually.
- Takes two to three years.
- Creditors will probably still call you.
Another option is to consolidate your debt. The idea here is that you get a new loan (a home equity loan or line of credit, personal loan, balance transfer credit card) and you use it to pay off your old loans.
This can benefit you if you can qualify for a loan with a lower overall cost than all of your existing loans combined. It can also make your debt easier to manage as you have one creditor instead of multiple.
Going this route, you won’t have any debt discharged or forgiven, but you can save your credit. However, the catch is that you will have to find a loan you can get that is large enough to cover your debts.
If you can’t, or your debt is beyond what you can repay in three to five years, it’s probably better to look into bankruptcy or debt settlement.
Debt consolidation can be a useful tool, but it’s not for everyone. Here are some things you should consider about debt consolidation before you make up your mind.
- Potentially lower the interest you pay on your debt.
- Combine all debts into one.
- Pay off debt and save credit.
- Repay debt in full plus interest.
- May not be able to get a large enough loan.
- Creates the opportunity for more debt if you keep using your credit cards.
- Can’t usually consolidate secured loans.
In some cases, if you owe a lot of money to the IRS, it can help to have a tax relief company on your side. The best tax relief companies have tax lawyers and enrolled agents on staff, provide a money-back guarantee and charge competitive rates. Check out which tax relief company is the best fit for you.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.