Understanding Bankruptcy

“I need a second chance!”

That is bankruptcy in a nutshell.

For whatever reason, your finances have gone sour, you’re drowning in debt, you’re sure you learned your lesson, so you scream for help: “Just give me a second chance!”

Bankruptcy will do that.

Bankruptcy is a legal do-over for consumer or business owners. You can petition U.S. Bankruptcy Courts to release you from debt and let you start your financial life with a clean slate.

And the good news is, in most cases, your request will be granted.

Two-thirds of the people filing bankruptcy in 2019, did so using Chapter 7 and their debts were discharged 94.3% of the time. If you filed the second most popular form of bankruptcy, Chapter 13, the success rate dropped to 44.4%, but that’s usually because the judge thinks you can manage your debts with the assets you have. In other words, the judge believes you’re going to be OK, so, it’s a success either way.

Bankruptcy is most often associated with someone living paycheck-to-paycheck, but it’s just as likely to happen to professionals and business owners. Dan LaBert, executive director of the National Association of Consumer Bankruptcy Attorneys, said bankruptcy provides “the chance for a fresh start and serves as a legitimate debt-relief option, regardless of someone’s station in life.”

So, what happens when you file for bankruptcy? This page will explain the process, giving options for individuals and providing information to help the understanding of bankruptcy.

Types of Bankruptcy

Officially, there are six types of bankruptcies – Chapters 7, 9, 11, 12, 13 and 15 – but 99% of bankruptcy cases filed in 2019 were Chapter 7 (liquidation) or Chapter 13 (personal reorganization).

The other four, Chapter 11 (business reorganization), Chapter 9 (municipalities); Chapter 12 (farmers) and Chapter 15 (cross border) make up the other 1%.

Chapter 7

Some people refer to Chapter 7 bankruptcy as “liquidation bankruptcy’’ because it discharges most of your unsecured debt by liquidating your assets. Going away are unsecured debts like credit cards, personal loans and medical bills.

It’s the quickest, simplest and most common type of bankruptcy, but first, you must qualify.

To qualify for Chapter 7 bankruptcy, you must pass Part 1 or Part 2 of your state’s means test. Part 1 has to do with income. If your household income is less than your state’s median income, you qualify. Remember that median income means half the people in the state have more income, half have less. If you have less, you qualify for Chapter 7.

If you have more than the median income, there is still a chance to qualify through Part 2 of the “means” test. In Part 2, you must document all your allowable expenses for the previous six months (rent, food, transportation, clothing, medical expenses, etc.) and subtract that from your income.

What’s left is called “disposable income” that can be applied to debt. If you’re disposable income is low enough, compared to your debt obligations, you may qualify for Chapter 7.

If you qualify for Chapter 7, it means the court trustee will sell non-exempt assets to pay off creditors. The definition of non-exempt assets varies from state-to-state, but just about anything that has value could be included. That means a nice car or home that has some equity, jewelry, art or stamp collections, musical instruments, electronic devices, etc.

The whole process for Chapter 7 can be completed in 6-8 months.

Chapter 13

Chapter 13 bankruptcy is also known as “reorganization bankruptcy.’’ You offer the judge a repayment plan that allows you to pay back creditors in 3-5 years. No property is required to be liquidated. For Chapter 13 bankruptcy, you must have regular income to make the required monthly payments.

There also are debt limit qualifications for Chapter 13 that you can’t exceed. You must have less than $394,725 in unsecured debt or less than $1.184 million in secured debt.

You will make monthly payments on your debts for 3-5 years and can’t take out any loans during that time. If you fail to make the payments, you likely will be back in court and your discharge rescinded.

Chapter 11

Chapter 11 bankruptcy is somewhat similar to Chapter 13, but it’s typically reserved for businesses. Essentially, it’s a reorganization or restructuring of the company. It’s possible for businesses to file for Chapter 7 bankruptcy, but that means a liquidation of assets, so Chapter 11 is a more attractive option. That allows businesses to maintain their assets and continue operations, but they must devise a plan to pay off some of their debt or get it forgiven.

What Is a Discharge?

A discharge is a court order that releases you from obligations to pay debts. It means that creditors or debt collectors must stop attempts to collect on the debts. That means no more harassing phone calls and filling your mailbox with threatening letters. In other words, discharge is your get out debt card.

Which Debts Are Discharged in Personal Bankruptcy?

Bankruptcy allows you to discharge debts in the following categories:

• Credit cards
• Auto loans
• Mortgages
• Medical bills
• Utility bills
• Personal loans

Which Debts Are Not Discharged in Bankruptcy?

The following debts are not forgiven in personal bankruptcy:

• Tax debt (although some IRS debt could be eligible for a payment plan)
• Alimony
• Child support
• Student loans

If you have luxury item purchases or cash advances received immediately prior to the bankruptcy filing, creditors can challenge that, saying these were premeditated transactions, and have them excluded.

Another consideration: A bankruptcy discharge is personal and protects you. But it does not eliminate the debt itself. For example, if you had a co-signer on a home loan and you file for bankruptcy, the lender can still seek to collect the debt from the person who co-signed the loan. This is important to remember if you have family members or friends co-sign a loan, but are not going to file for bankruptcy.

What Are Potential Effects of a Discharge?

The immediate effect of a bankruptcy discharge is that your credit score will plummet and a notation will be added to your credit report saying you failed to pay your debts as agreed. That will stay on your credit report for 7-10 years.

How far your credit score plunges depends on where you stood at the time of the discharge. If you were above 700, for example, figure on a 100 to 150-point drop. If you were at 600, it’s more likely to be 75-100 point drop.

Reaffirming a Debt

Reaffirming debt means that you sign, and file with the court a legally enforceable document, which states that you promise to repay all or a portion of a debt that may otherwise have been discharged in your bankruptcy case. Reaffirmation agreements must generally be filed with the court within 60 days after the first meeting of creditors. Reaffirmation agreements are strictly voluntary — they are not required by the Bankruptcy Code or other state or federal law.

What Are the Effects of Reaffirming a Debt?

If you reaffirm a debt and fail to make the payments required in the reaffirmation agreement, the creditor can take action against you to recover any property that was given as security for the loan and you may remain personally liable for any remaining debt.

You can voluntarily repay any debt instead of signing a reaffirmation agreement. Reaffirmation agreements must not impose an undue burden on you or your dependents and must be in your best interest. If you decide to sign a reaffirmation agreement, you may cancel it any time before the court issues your discharge order or within sixty (60) days after the reaffirmation agreement was filed with the court, whichever is later

Cost of Bankruptcy

Though your finances may be in bad shape, filing for bankruptcy can still cost you a significant amount of money. Retaining a bankruptcy attorney could cost you several thousand dollars.

If you prepare and file your own bankruptcy case, the filing fees alone are substantial and your chances of success are greatly reduced.

According to the National Bankruptcy Forum, the average cost of a Chapter 7 bankruptcy is $1,250.

Bankruptcy on Your Credit Report

Chapter 7 bankruptcies will remain on your credit report for 10 years. Chapter 13 bankruptcies remain on your credit report for seven years.

Bankruptcy Education

As part of any bankruptcy filing, there’s a required educational process.

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, consumers must undergo pre-file credit counseling 180 days before filing for bankruptcy. The counseling provides education about the process and alternative debt-relief options.

After filing, consumers must complete a pre-discharge course (mandatory to have your debts discharged) about personal financial management. It’s designed to prevent additional and future financial difficulties. It will provide structure for managing your money, creating and maintaining a budget, and using credit appropriately.

Should I Declare Bankruptcy?

There is a reason bankruptcy is called the “nuclear option” for debt relief. It should only be considered if you already have tried – and failed – to make a dent in your debt obligations using other debt-relief options.

If that’s the case, consider the pros and cons before deciding to push the button.

Pros of Bankruptcy

• Eliminates or reduces debt for people in dire financial situations, perhaps due to illness or loss of a job.
• Temporarily prohibits creditors from foreclosing on a home or repossessing a car.
• Temporarily prevents wage garnishment, debt collectors’ harassment or disconnection of utilities.
• Allows consumer to get a “second chance” with their finances.

Cons of Bankruptcy

• Affects credit record for up to 10 years, creating problems in obtaining loans for cars, homes.
• Becomes a public record that can be viewed by potential employers, insurance companies, banks and other lenders.
• It will be extremely difficult to get a mortgage after bankruptcy. You may not qualify for loans for several years, especially mortgage or home equity loans. And if you get loans, the interest rates will be higher because of the risk.

What Is Judgement Proof?

Judgment proof describes a person whose income is too meager to settle debts with a creditor and whose assets are protected from liquidation by federal law.

A person may own some assets of value – Social Security, Disability, retirement accounts, ERISA Pensions, Veteran’s benefits, worker’s compensation benefits, public assistance, child support and alimony – but these are protected by federal law and thus considered judgment proof.

The income from these sources is used for everyday expenses such as rent, utilities, food, clothing, etc. Taking that income away to pay off debts could leave the person homeless and struggling to survive. That’s why they are protected.

Bankruptcy Alternatives

If your income is too high for a Chapter 7 bankruptcy, there are other financial options available besides a Chapter 13 bankruptcy.

The best way to determine how to deal effectively with your debt is to contact a nonprofit credit counseling agency like InCharge Debt Solutions and let their certified counselors review your budget or offer help creating one that puts you on more affordable financial footing.

The goal is to determine which relief option will help you eliminate debt and regain control of your finances. And the service is FREE!

Some options that might help your situation include:

Debt Management Plan — Entering a debt management plan can provide enough relief to allow you to eliminate credit card debt over a 3-5 year period. Under debt management, credit counselors work with lenders to reduce interest rates, fees and penalties to an affordable level. In return, you promise to pay back the full principal over time in an efficiently managed manner.

Debt Consolidation Loan — This option combines all your debts into one manageable bill and pays them off with a single loan that has a reduced interest rate. Look for an dependable, experienced debt consolidation company and be wary of consolidating several unsecured loans into one secure loan, meaning one backed by collateral like a home or car.

» More About: Debt Consolidation vs. Bankruptcy

Debt Settlement — This is an attempt to convince creditors to accept less than what is owed on their debt, maybe even as much as 50% less. It’s a great deal if you can get it, but debt settlement causes significant damage to your credit report and many creditors refuse to deal with it.

Is Bankruptcy Right for You?

Bankruptcy is losing some of the negative image it carries as people realize getting a second chance – even financially – is actually a good thing. But treat the process respectfully. Use the course in pre-bankruptcy filing and pre-discharge to learn more about alternative debt-relief solutions and ways to manage your money successfully.

Without debts, you can start on the road back to financial health. Setting up a budget, paying closer attention to spending habits and applying for a secured credit card are some preliminary steps to re-establishing credit. Handling loans and credit in a responsible manner – i.e. paying all bills on time – is a good way to build on that credit.

If you’ve been granted a second chance, take advantage of it, but remember, the goal is bankruptcy is to never come back.

Chapter 7 Bankruptcy

Chapter 7 bankruptcies are designed to liquidate the debtor’s assets. All property, except that which a petitioner is allowed to keep, is turned over to a bankruptcy trustee who disburses the debtor’s funds to creditors in an effort to repay part of the debts that are owed.

Chapter 13 Bankruptcy

Chapter 13 bankruptcies are debtor reorganization proceedings that encourage the consumer to repay as much of the debt as possible. A regular income is required to secure a Chapter 13 repayment plan, which usually lasts three to five years.

Bankruptcy Education Courses

Approved by the U.S. Trustees, InCharge issues Bankruptcy Code-compliant certificates for required pre-filing counseling and pre-discharge education. If you file for bankruptcy, you must attend a Pre-Filing Credit Counseling session. After filing, you must complete Pre-Discharge Debtor Education before your bankruptcy is finalized. InCharge offers both of these educational courses.