Bankruptcy: Understand Your Options
- If you’re considering bankruptcy, you have several options.
- The most common filings for individuals are Chapter 7 and Chapter 13.
- Individuals can also file Chapter 11.
What is bankruptcy?
Bankruptcy is a formal legal process available to those who cannot pay their debts without significant hardship. It is primarily governed by federal law, though some details can vary from state to state.
The value of bankruptcy is that it requires all current debt collection efforts to stop. The bankruptcy court determines how much you pay your creditors and what form that repayment will take. Bankruptcy can not only make dealing with your debts more manageable, but it could also mean paying less than the total amount you owe.
However, bankruptcy comes at a steep cost. Filing may mean giving up some of your assets or years' of income to put towards your debts. It stays on your credit record for 7 to 10 years. You will find it difficult or very expensive to get a mortgage or finance a car for years after filing bankruptcy. Some careers are off-limits, and insurance costs increase as well. Finally, filing bankruptcy turns your private financial troubles into a public record.
And after all that, bankruptcy may not get rid of all of your headaches. Some obligations cannot be discharged, including:
Debt from death or injury you caused while driving under the influence
Legally, student loans can only be discharged if you can prove “undue hardship.” Recent trends in courts and Congress may soon make it easier to discharge student loans through bankruptcy.
In any case, bankruptcy is not a complete solution in terms of either the amount or types of debt that can be resolved. However, it may be the best option for making debt manageable enough for you to get back on your feet financially.
There are three major types of bankruptcy: Chapter 7, Chapter 13, and Chapter 11, and your situation determines which form is most suitable.
Chapter 7 is the most common form of bankruptcy for individuals. With Chapter 7, you surrender your assets to the court, which sells them and divides the proceeds among your creditors. Any remaining balances are discharged. For this reason, Chapter 7 is also called a “liquidation bankruptcy.”
Before you can file a Chapter 7 bankruptcy, you must pass a “means test” to determine if you’re eligible. To pass a means test, your income in the prior six months can’t have exceeded the median income in your state for families the size of yours.
When you file a Chapter 7 bankruptcy, the court requires the sale of many of your personal assets. Some items may be partially or wholly exempt, including
Equity in your primary residence
Tax-exempt retirement funds
The type and amount of exempt property depends a great deal on the state in which you file. Some states have broader exclusions from what you can be forced to sell to pay debts and allow you to choose whether to follow the state or federal guidelines.
Proceeds from the property sale go first toward secured debt. Anything left goes to unsecured creditors. Any unsecured debt that can’t be covered by the sale is discharged.
At that point, you should be free of most of your previous debt burdens, but it’s not a completely fresh start. A Chapter 7 bankruptcy stays on your credit report for 10 years.
People who don’t meet the means test for a Chapter 7 bankruptcy usually file Chapter 13. While Chapter 7 bankruptcy focuses largely on using your assets to pay your debts, Chapter 13 focuses on using your income over time. For this reason, it is also called a “wage earner” bankruptcy.
When you file Chapter 13, the court examines your income and debts and determines what you can afford to pay. Every month for up to five years, you pay the required amount into the plan, and the court divides it among your creditors. Each year, you must submit tax returns to the court so it can adjust your payment if your income changes.
Once you are enrolled in a Chapter 13 plan, collection efforts cease. If you complete the plan, any remaining balances are discharged. You don’t have to give up any assets.
Chapter 13 is not an easy way out of debt, however. For one thing, you don’t get to negotiate with your creditors – the court decides how much you can afford to pay, and that might be more than you think you can afford. This may require a radical change in lifestyle.
Another downside is what can happen if you miss a payment into your plan. The court may dismiss your case, allowing your creditors to resume collection attempts and even sue you. If your income falls too far, the court may convert your case to a Chapter 7 and take your assets to repay your creditors. Think that won’t happen? According to the American Bankruptcy Institute, only about one-third of Chapter 13 bankruptcies conclude successfully. Rates by state range from 40% to 70%.
Chapter 13 bankruptcy stays on your credit record for seven years after discharge. If you complete a five-year plan, you have a bankruptcy on your report for 12 years altogether. However, many lenders look more favorably on Chapter 13 than Chapter 7.
Chapter 11 bankruptcy is most commonly used by businesses, but it can also be an option for individuals who have too much debt to qualify for a Chapter 13 bankruptcy.
The debt limits for a Chapter 13 bankruptcy are $419,275 in unsecured debt and $1,257,850 in secured debt. These limits are reset every three years. So, if you have more debt than that and need to declare bankruptcy, Chapter 11 may be your only option.
The downside is that it is a more complex, more expensive, and longer-lasting type of bankruptcy. Chapter 11 involves filing a detailed plan for debt repayment with a US Treasury bankruptcy trustee. Your creditors will have the opportunity to object to that plan before it is approved.
While waiting for approval, you must file a monthly report showing all income and disbursements. After approval, you must file quarterly reports until the repayment plan has been fulfilled. You also have to pay a quarterly fee to the US Treasury Trustee System, which is based on your disbursement amounts.
Because of the size of the debts involved, Chapter 11 repayment plans can sometimes take decades to complete. Having your income and expenditures overseen for that long can be quite a burden. However, if you can’t meet the income test for a Chapter 7 bankruptcy and have too much debt for a Chapter 13, this might be the only bankruptcy option left to you.
Which Type of Bankruptcy is Right for You?
To help summarize the descriptions in the preceding sections, the following table shows how these bankruptcy types apply to different situations:
|Bankruptcy Type||Income Level||Debt Amount|
|Chapter 7||Low - less than the median in your state for your household size||Any|
|Chapter 13||Any||Less than $419,275 in unsecured debt and $1,257,850 in secured debt|
|Chapter 11||Any||High - above the limits for Chapter 13 bankruptcy|
Bankruptcy is a complicated process with long-lasting consequences. A simple table cannot fully describe all of the factors that should go into deciding whether to pursue it. This is intended just as a starting point for further research.
Things to Try Before You Declare Bankruptcy
The title of this article refers to bankruptcy as a last resort. That means there are some things you should try before looking into bankruptcy.
Debt negotiation. Try asking your creditors for more time or better terms.
Debt consolidation. See if consolidating your debt into a lower-interest loan or a debt management plan (DMP) makes it more affordable and easier to manage.
Credit counseling. Get advice from a qualified debt counselor about how to handle your debt problem.
Debt relief. Explore whether it’s worthwhile to pay for a professional to deal with creditors on your behalf.
If none of the above works for you, then your next step might be to get advice from a qualified bankruptcy attorney as to your options and their consequences.