Getting hopelessly upside-down in our financial lives can happen to the best of us. (Ask the current occupant of the White House.)
But when your debts far outweigh your ability to pay and insolvency looms like a sledgehammer, it’s good to know there’s an approved cure for your hopelessness.
Yes, we’re talking about bankruptcy, specifically Chapter 7 bankruptcy.
Chapter 7, also known as “straight bankruptcy” or “liquidation bankruptcy,” is probably what most people imagine when they think of bankruptcy at all, but there are qualifying standards that mean not everyone can take advantage of it.
The standard is called a “means test” and it’s used to limit the number of people who file for Chapter 7 bankruptcy.
What Is Chapter 7 Bankruptcy?
Simply put, when you file for Chapter 7 bankruptcy, all your non-essential possessions are sold. That money is split between your creditors.
And even if it’s not enough to pay off all those bills, your debts still are forgiven and you can start again from scratch.
It’s a way to have most of your unsecured debt wiped away. There are some exceptions that can’t be wiped away: student loans, child support, alimony and tax debt.
It may sound like a Get Out of Jail Almost Free card, but there are serious ramifications. A Chapter 7 bankruptcy stays on your credit report for 10 years.
That will make it harder to get a loan. If you do get one, the interest rate will be higher than normal.
Here’s a list of debts that are typically covered in a Chapter 7 bankruptcy:
- Medical bills
- Credit card bills
- Utility bills
- Personal loans
- Some government bills
How to File and the Chapter 7 Bankruptcy Process
You can file for Chapter 7 bankruptcy on your own, though you should seriously consider hiring an attorney. There’s a lot at stake here, and the process can get pretty complicated. It usually takes four to six months to complete a Chapter 7.
Here how the process will evolve:
- Fill out forms: They can be downloaded from the U.S. Courts website using this link.
- Take a credit counseling course: Individual and group courses are offered by credit counseling agencies. They are required before filing.
- Pass a “means test”: This will determine whether you are eligible to file for Chapter 7 bankruptcy. If your income is below the median income in your state, you qualify. Another way is if your expenses are so high and your income so low that you will never have enough money to pay off debts, you might qualify.
- File the forms: If you are under time pressure and have not completed all forms, you can opt for an emergency filing of required forms and submit the rest within 14 days. Filing fees vary by state, but average around $350. You can apply for a waiver based on your income.
- Send your documents to a trustee: The court-appointed trustee verifies the information in your forms. The documents include tax returns, bank statements, paychecks and business documents.
- Attend a creditor meeting: It’s a meeting with the trustee and creditors, though creditors are not required to attend and rarely do. The trustee will put you under oath and ask standard questions about your debt situation. The meeting is generally brief unless something unusual pops up.
- Attend debtor education course: This is the second “financial literacy” course and must be completed within 60 days of your creditor meeting. You must submit your certification of completion to the court, or the judge might dismiss your case.
- Receive your discharge: The court issues an order discharging you of your qualifying debts. That permanently stops creditors from trying to collect from you.
Do I Meet the Qualifications for Chapter 7 Bankruptcy?
If you do, chances are you’ll eventually walk away with a new lease on financial life.
The American Bankruptcy Institute reported that 94.3% of Chapter 7 filings between Oct. 1, 2018 and Sept. 30, 2019 were successfully discharged, meaning filers were no longer required to pay the debt.
Here are the standard requirements to qualify for Chapter 7 bankruptcy:
- You must pass a “means test,” which looks at your income, assets and expenses.
- You cannot have filed a Chapter 7 or Chapter 13 bankruptcy petition that was dismissed in the previous 180 days.
- You cannot have completed a Chapter 7 in the past eight years, or a Chapter 13 in the previous six years.
What Is a Means Test?
A “means test” is a formula that determines whether you have the means (income) to pay your debts or don’t have the means (income) and are eligible to file for Chapter 7 bankruptcy.
You determine your “current monthly income” by averaging your monthly income over the six months prior to filing for bankruptcy. If it less than the median monthly income of your state, you qualify for Chapter 7.
Median income varies quite a bit. According to a 2019 U.S. Census Bureau report, Maryland has the highest annual median income at $83,242. West Virginia had the lowest at $44,097.
If your median income exceeds the state average, you can still qualify for Chapter 7 bankruptcy. That’s because you are allowed to deduct certain expenses (like mortgage and car payments) from your income total.
If your monthly income still exceeds the state average, you will have to file for Chapter 13 bankruptcy.
In a bit of relatively good news for people wanting to file Chapter 7 bankruptcies, the money they get from coronavirus CARES Act passed in March 2020 does not have to be included in determining eligibility.
When to File Chapter 7 Bankruptcy
Bankruptcy is a last resort maneuver that has long-lasting consequences. That said, sometimes it is unavoidable. It makes sense if:
- You’ve tried negotiating with creditors and cannot reach a payoff agreement.
- You’ve had credit counseling and still struggling to manage your debt.
- You determine it would take at least five years to pay off your debt, even if you took extreme measures like eating Ramen noodles every night.
- Problem debts like credit cards, personal loans and medical bills total more than 40% of your income.
- You are tempted to maim the next collection agency representative who calls you.
Chapter 7 Bankruptcy Pros and Cons
To help you decide whether you’ve reached the last resort and it’s time pull the trigger, here are some things to consider.
Pros of Chapter 7 Bankruptcy
- Your out from under what likely was a heavy load of unsecured debts.
- State exemptions generally exempt most of your possessions from liquidation. After you file for Chapter 7, you will keep your salary (except for certain court-mandated deductions mentioned above like IRS garnishments, alimony, child support, etc.) and property you buy.
- It may be possible to obtain new lines of credit as soon as a year out from filing, but be ready to pay staggering interest rates.
- Some specialty lenders will take on so-called “bad risks,” an unfortunate term that fails to account for the integrity of someone who has taken the bold step of setting right his financial woes.
- Bankruptcy may make it easier to meet your court-ordered obligations. Also, bankruptcy wards off aggressive debt collectors that have no problem violating the collections guidelines.
Cons of Chapter 7 Bankruptcy
- Chapter 7 bankruptcy is the ultimate hit on your credit rating. It is your legal confession that, at one time, you could not manage debt. And it sticks with you for 10 years.
- You may lose “non-essential” property like certain luxury items, or even priceless family heirlooms that are sold to pay off creditors.
- You have to fill out a lot of forms, some of which can get maddeningly complicated.
- Say goodbye to your credit cards. So long, Capital One miles. Farewell, Marriott Rewards points. What’s in your wallet immediately after Chapter 7? Cash, an ATM card, and personal identification.
- If you don’t have a mortgage, getting a mortgage after bankruptcy will be extremely difficult to obtain.
- You must be confident of the path forward. Completing the Chapter 7 process means you’re barred from seeking Chapter 7 relief again for at least six years, dating from when you last filed for bankruptcy.
- Bankruptcy will not get you off the hook for alimony and/or child support. You also still have to pay off your student loans, IRS debt and fines.
Chapter 7 Bankruptcy Alternatives
As desperate as your financial situation may be, bankruptcy is not the only escape. Here are other options you might qualify for:
- Debt consolidation loans: Get a personal loan from a bank, credit union or other lending institution that will pay off your problem debts and consolidate your debt into one loan. That will leave you with one monthly payment, which will likely have lower interest charges than what you were previously paying.
- Credit counseling: Nonprofit agencies offer free credit counseling that usually includes a budget review and debt analysis. They might recommend a debt management program, in which your debts are consolidated and you pay them off in a program that lasts three to five years.
- Home equity loans: With a loan, you borrow against the equity you have in your house. For instance, if the appraised value is $300,000 and you owe $200,000, you have $100,000 in equity. You borrow that sum and pay it back in monthly installments. But be warned: failure to pay could lead to repossession of your house.
- Debt settlement: A third-party agency tries to negotiate a reduced lump-sum settlement with your creditors. On this one, be warned that scams abound and creditors might not budge, leaving you in worse financial shape than when you started
- Do nothing: If your income is limited to Social Security or disability payments, and you have only essential property like ordinary clothing and household furnishings, you might be “judgment proof.” That means creditors can hound you all they want, but they can’t actually collect anything since your income is protected and you don’t have any other assets.
This option will have the same ruinous effect on your credit score as filing bankruptcy, but at least you won’t have to hassle with filling out any forms.