Bankruptcy Overview: What It Is And How It Works?

Bankruptcy is a legal process that clears out your debts or creates a payment plan to creditors, allowing you to catch up. 

Businesses, farmers, municipalities, and individuals can file for bankruptcy.

While wiping out your debts might sound appealing, there are downsides. Plus, some debts, like student loans, are notoriously difficult to get removed in bankruptcy. But in some cases, it might be the best option.

Let's dive into bankruptcy and see what it all means.

What Do The Numbers/Types Mean?

There are two types of personal bankruptcy — Chapter 7 and Chapter 13.

Chapter 7

Chapter 7 bankruptcy is a liquidation of your debts — it wipes out most of your unsecured debts. For cleared debts, there is no return to creditors. Chapter 7 is considered a simple and straightforward process.

The process can take three to four months to complete. With Chapter 7, you also get legal protections. For example, if someone has sued you, that basically goes away with other debts. If your home is being foreclosed on, the foreclosure is stopped, so you have time to work out an arrangement with the lender.

You must qualify for Chapter 7 through your state’s specific means test. One qualifying factor is your income. If your household income is $85,000 but your state’s median income is $65,000, you fail the means test and do not qualify for Chapter 7 bankruptcy. In addition to the means test, you also can’t have filed for Chapter 7 in the last six years.

A court decides which of your assets to sell. You can have exemptions for items such as your car, home, and retirement savings. Exemptions are state-specific. Keep in mind that your home can still be sold depending on what you owe and what the value of the home is. Expect any luxury items such as a boat and second home to be liquidated.

Some debts cannot be discharged, such as taxes, alimony, child support, and student loans.

Chapter 7 will stay on your credit report for ten years. While you can still apply for credit, your rates are likely to be terrible. But each person’s situation is different. Some people are able to bounce back within a year to a fairly good credit score, allowing them to obtain automobile financing. The cost of filing Chapter 7 is $335.

Chapter 13

Chapter 13 is a reorganization bankruptcy. It is a forced court-created repayment plan lasting 3-5 years. Most are five years. If there are debts remaining after five years, they are discharged. Chapter 13 is for people who have an income but need some space with creditors. In other words, they need creditors to lower payments, allowing the debtor to catch up.

Onc advantage of Chapter 13 is that you can keep you home. Any foreclosure that is in process will be halted in Chapter 13. Unlike Chapter 7, properties are not sold. Credit card and medical bills may be discharged. To be eligible, must have regular income and unsecured debts of less than $394,725, and secured debts of less than $1,184,200. Tax debt (i.e., property taxes), child support, and again student loans are not eligible. The cost of filing Chapter 13 is $310. 

If you miss any payments while in the plan, you can lose all of your protections and the benefits of the plan. In that case, you go through all of the trouble of filing for bankruptcy only to be back where you were before filing.

Chapter 13 payments are not made directly to creditors. Instead, the debtor sends payments to a mediator, who then sends the payments to creditors. There is no contact between the debtor and creditors during the payment plan.

Chapter 13 will stay on your credit report for five years.

For both bankruptcies, if you decide to use a bankruptcy attorney, the cost can range from a few hundred dollars to a few thousand dollars.

Can It Really Help?

Yes, assuming you have a plan for fixing your finances. If you see no light at the end of the tunnel because of crippling debt, wiping out your debt can give you a fresh start.

However, if you don’t have an income or don’t have a plan to increase your income or create a budget, filing for bankruptcy may not help in the end.

And remember, the bankruptcy won't eliminate the past damage done to your credit. So you'll still have years of poor credit scores before you'll see that resolved.

What About Student Loans?

Unfortunately, student loans are notoriously difficult to eliminate when you file for bankruptcy. The only way to get rid of student loans is if they are causing undue hardship on the borrower or dependents. Undue hardship is difficult to prove and only a small number of people who file for bankruptcy actually succeed in discharging their student loans.

The reason? With income-driven repayment plans that allow your monthly payment to be $0 per month, is there really a hardship?

However, for borrowers with private loans that don't have access to these types of programs, there are more options.

See our full guide to student loans and bankruptcy.

Final Thoughts

Filing for bankruptcy has its positives if you have a plan to turn the situation around and not wind up back where you started. Keep in mind that bankruptcies become public record. Employers and any co-signers may be notified once you file. You’ll have to answer “yes” on any application asking if you’ve ever filed for bankruptcy.

It truly is an event that will be with you in one form or another for the rest of your life.