Understanding Bankruptcy and Debt
- Bankruptcy is a legal process that may reduce or eliminate debt you can't repay.
- Chapter 7 bankruptcy may wipe out debts, while Chapter 13 bankruptcy requires a repayment plan.
- Alternatives to bankruptcy include debt management plans, debt consolidation, and debt settlement.
Table of Contents
Free up cash each month with Freedom Debt Relief
Ozzy S., Freedom client²
“Right away, I had more money each month because of program costs so much less than what I was paying on my minimums.”
Bankruptcy is a legal process that may reduce or eliminate debt you're unable to repay. It's one option among several if you're carrying more debt than you can manage, alongside approaches like debt settlement, debt management plans, and debt consolidation.
This guide explains how bankruptcy works, when it may apply to your situation, and what alternatives to bankruptcy exist so you can compare your options with clear, direct information. Compare each option carefully, since the path that fits your situation depends on your income, your assets, and the type of debt you owe.
What Is Bankruptcy?
Bankruptcy is a legal option for debt relief that takes place in the bankruptcy court system. When you file for bankruptcy, the court appoints an impartial trustee to review your paperwork and manage your case. At the end of a successful case, the court issues a discharge order that cancels your eligible debts.
Not all bankruptcies are the same. The type of bankruptcy you file depends on your personal circumstances and qualifications. The two most common types of personal bankruptcy are Chapter 7 and Chapter 13.
Chapter 7 bankruptcy
Chapter 7 bankruptcy is often the preferred type to file since it may wipe out eligible unsecured debts with little or no repayment. Credit card debt and personal loans are generally eligible to be wiped clean in a bankruptcy, for example. Your mortgage (secured by your home) or your auto loan (secured by your car) aren’t eligible to be wiped clean with bankruptcy.
In a Chapter 7 bankruptcy, you may be required to give up some of the things you own. In all states, there are things you're allowed to keep. Those are called bankruptcy exemptions. Anything else would be called a nonexempt asset. Nonexempt assets typically include things like a second car or a rental property. You might even have to sell your home if you have more equity than what your state allows you to keep in a bankruptcy.
The trustee sells nonexempt assets and gives the proceeds to your creditors. You must pass a means test to be eligible for Chapter 7. The means test tells the bankruptcy judge whether you could afford a monthly payment. If you can, you may not be eligible for Chapter 7. The court may require you to convert your case to Chapter 13 bankruptcy, or dismiss it outright.
Chapter 7 is best for people who have a lot of unsecured debt, like credit card debt, few or no nonexempt assets, and income that doesn't leave a lot leftover after covering basic necessities.
Chapter 13 bankruptcy
Chapter 13 bankruptcy is used by people who don't qualify for Chapter 7, or who want to protect their nonexempt assets. It's a way to stop a home foreclosure, at least temporarily. Chapter 13 is for people who could afford a payment and could repay at least some of their debts. Some debts could be discharged through Chapter 13.
You have to agree to a structured repayment plan approved by the court. You make payments for three or five years, depending on your income. At the end of your repayment plan, the court discharges your remaining unsecured debt. Chapter 13 also reviews your income. If your income is above your state's median, that review helps set your monthly plan payment and how long the plan lasts. Chapter 13 eligibility isn’t tied to your income the same way Chapter 7 is.
Debt That Bankruptcy Doesn't Discharge
Bankruptcy might include nearly every type of debt. How each type is treated depends on whether it's dischargeable. Discharge cancels a debt so you no longer owe it, and it applies to most unsecured debt, like credit cards, medical bills, and personal loans. Several types of debt are generally not discharged, including:
Child support and alimony: These obligations continue after your bankruptcy case closes.
Recent income tax debt: Income tax generally isn't discharged if the return was due, including extensions, less than three years before you file. Older income tax debt could be discharged if it meets several other conditions.
Court fines and criminal penalties: Bankruptcy doesn't cancel these, since they're a penalty rather than a financial debt.
Debt from fraud that you committed. The creditor asks the court to exclude the debt from bankruptcy, and the judge decides.
Debt from an injury caused while driving under the influence: These debts generally aren’t eligible for discharge.
Most federal and private student loans: You'd need to file a separate legal action, called an adversary proceeding, and prove undue hardship to discharge them this way.
A debt that isn't discharged still exists after your case closes, and you remain responsible for it. Chapter 13 plans could still include nondischargeable debt, like recent tax debt, alongside the debt the plan discharges, since the goal is to organize all of your payments into one plan. A bankruptcy attorney will be able to review your specific debts and tell you which ones are likely to survive your case.
How Bankruptcy Works, Step by Step
Every bankruptcy case is different. In general, the process goes like this:
Consult a professional. You could file for bankruptcy on your own. It's recommended that you consult a bankruptcy attorney to understand your options and ensure you're meeting all necessary requirements. It can be confusing, and the specific laws also vary by state. People who hire a bankruptcy attorney have better outcomes, on average, than people who don't. That's especially true for Chapter 13 cases.
Determine the type of bankruptcy you want to file. This depends on your needs and qualifications. If you're unsure, a bankruptcy attorney can help you figure it out.
Take your pre-bankruptcy credit counseling course. Most people must take an approved credit counseling course no more than 180 days before filing for bankruptcy.
Gather your information and documents. You’ll list all of your assets, debts, income, and expenses in your bankruptcy filing forms. You should also gather financial documents like W-2s, tax returns, and bank and investment account statements.
File your bankruptcy petition. The bankruptcy process doesn't officially start until you (or your attorney) file your petition with the bankruptcy court. This involves a lot of paperwork and paying some fees.
The automatic stay goes into effect. When you file for bankruptcy, you typically get an automatic stay. This is a legal order that makes debt collectors stop trying to collect on any debt. It may also freeze foreclosure or eviction proceedings. The automatic stay does not excuse you from paying your mortgage. If you don't make your payments, your mortgage lender could ask the judge to lift (cancel) the automatic stay for that debt.
The court assigns a bankruptcy trustee. When you file, the court assigns a trustee to oversee your case. This is the person who reviews your petition.
Attend the 341 (creditors') meeting. About a month after filing, you attend a 341 meeting, also called a creditors' meeting. At the meeting, the trustee confirms your identity and you answer questions about your petition.
Complete your debtor education course. To receive your final discharge, you need to take an approved debtor education course. (This is different from the pre-bankruptcy credit counseling course.) In Chapter 7, you file proof of the course within 60 days after the first date set for your 341 meeting. In Chapter 13, you finish it before your last plan payment. If you skip the course, the court could close your case without a discharge.
Wait for the court's decision. Bankruptcy isn't an overnight process. It typically takes several months to get a final decision from the court after filing your petition.
Follow your bankruptcy plan. Filers of Chapter 13 bankruptcy receive a debt repayment plan as part of their bankruptcy. Plans typically last three years if your income is below your state's median and five years if it's above. If you filed Chapter 7 bankruptcy, the bankruptcy could discharge your eligible unsecured debts within a few months.
Bankruptcy and Your Credit
The impact bankruptcy has on your credit depends a lot on the state of your credit before you file. If your credit is already affected by missed payments, collections, or a foreclosure, bankruptcy may not make it much worse.
Once your bankruptcy discharge is completed, you could begin to rebuild your credit. Most negative items age off your credit report after seven years, and Chapter 7 bankruptcy falls off after 10 years. Chapter 13 lasts 10 years. The impact fades over time, especially if you build a new positive payment history and avoid new credit card debt.
A secured credit card is one option to rebuild credit after bankruptcy. You may find secured cards with no annual fee that report to all three credit bureaus. Make your payments on time every month and pay your balances in full to avoid new debt.
A few other options might also help rebuild credit after bankruptcy.
A credit-builder loan holds your payments in a separate account until the loan term ends, then releases the funds to you, which adds a positive payment history without a large upfront cost.
A family member could add you as an authorized user on an account in good standing, since their payment history could then appear on your credit report too.
Freedom Debt Relief is not a Credit Repair Organization and does not provide, or offer, services or advice to repair, modify, or improve your credit.
How to Get Credit After Bankruptcy
New credit becomes available gradually after bankruptcy. The wait for a mortgage is usually one to four years from your discharge date. Chapter 7 filers typically wait longer than Chapter 13 filers. Auto loans and personal loans might come with a shorter wait. Some credit cards and small loans become available sooner, sometimes within a year of your discharge.
Be cautious when taking on new credit. Most lenders that work with recent bankruptcy filers charge higher interest rates in exchange for the added risk. Also, another bankruptcy discharge isn’t an option until a waiting period has passed. The clock starts on the filing date of your first case.
Credit waiting periods after bankruptcy
| First case | New case | Waiting period |
|---|---|---|
| Chapter 7 | Chapter 7 | 8 years |
| Chapter 7 | Chapter 13 | 4 years |
| Chapter 13 | Chapter 13 | 2 years |
| Chapter 13 | Chapter 7 | 6 years |
When to Choose Bankruptcy
Bankruptcy might be the right choice for you if:
You have unmanageable credit card debt. Unsecured debts, like credit cards, are some of the most commonly discharged debts during bankruptcy.
You're overwhelmed by medical debt. Medical bills are generally dischargeable, meaning bankruptcy could get rid of them.
You're unemployed and can't make debt payments. Bankruptcy may help you get rid of debt so you can plan your finances going forward.
You're facing foreclosure. Chapter 13 bankruptcy may help you restructure your debts and save your home.
You've tried other debt relief options without success. Bankruptcy may be an effective tool for debt relief when other options haven't worked.
Alternatives to Filing for Bankruptcy
Financial coaching
There's a reason that the bankruptcy process starts with a required credit counseling course: Sometimes all you need is help and guidance. If you have the income to pay your debts, and you're still struggling, a financial coach or financial counselor may be able to help you get back on track. This kind of support may also help even if you ultimately choose bankruptcy or another option, since it gives you a clearer picture of where your money goes each month.
Refinancing and consolidation
Debt refinancing means you take on new debt to pay off your old debt. This is useful if you could get a lower interest rate on the new debt, which could reduce the interest fees you pay. If you use the new debt to pay off multiple existing debts, you also consolidate your debts into one monthly payment. This strategy requires a good credit score. Consolidation loans typically come with a fixed interest rate and a set repayment term, which makes your monthly budget more predictable.
Debt settlement
Debt settlement is the process of negotiating with your creditors to settle, or get rid of, your debt for less than you owe. This may be an option if you can afford to repay only part of your debt. You may attempt debt settlement on your own or you might hire a professional debt settlement company. Debt settlement takes several years and doesn't have a fixed end date the way a consolidation loan does, since it depends on when your creditors accept an offer.
Debt settlement may negatively impact your credit.
Debt management plans (DMPs)
Many nonprofit credit counseling agencies offer debt management plans. A DMP is a structured repayment plan. You make a single payment to the credit counselor, who then pays your creditors. When you set up a DMP, the counselor negotiates with your creditors for lower interest rates and fee waivers. You don't get to pick your monthly payment. It's high enough to pay off all of your unsecured debt in three to five years.
Key Bankruptcy Terms to Know
Here are a few terms that come up often in bankruptcy cases:
Automatic stay: A court order that stops most debt collection activity while your case is open.
Discharge: The court's cancellation of a debt, which releases you from paying it.
Exemption: Property that state or federal law lets you keep during bankruptcy.
Means test: A review of your income and expenses that determines whether you qualify for Chapter 7.
Trustee: The person the court appoints to review your case and manage your assets or repayment plan.
Liquidation: The sale of nonexempt property, with the proceeds going to your creditors.
Unsecured debt: Debt that isn't backed by collateral, like a credit card or medical bill.
These terms appear throughout this guide and in most bankruptcy paperwork, so it helps to recognize them before you file.
Bankruptcy is a financial decision for serious debt. Like any other debt solution, it’s right for some people. Bankruptcy is a legal tool, and for some people it's the best financial decision available. A licensed bankruptcy attorney in your state can review your debts, income, and exemptions and explain how bankruptcy might apply to your situation. You've already taken a solid first step: You now know how the process works.
Author Information
Written by
Brittney Myers
Brittney is a personal finance expert and credit card collector who believes financial education is the key to success. Her advice on how to make smarter financial decisions has been featured by major publications and read by millions.
Reviewed by
Lindsay Vansomeren
Lindsay is a writer for Freedom Debt Relief. She's passionate about helping people learn how to manage their money better so that they can live the life they want. She enjoys outdoor adventures, reading, and learning new languages and hobbies.
Frequently Asked Questions About Bankruptcy
Will filing bankruptcy mean owing more taxes?
The debts discharged during your bankruptcy aren't considered taxable income by the IRS, so you won't need to claim them as income on your taxes.
Can you declare bankruptcy for credit card debt?
Yes, you may file bankruptcy for credit card debt you're unable to repay. You could file under either Chapter 7 or Chapter 13. Chapter 7 typically discharges credit card debt unless it involved fraud, luxury purchases made shortly before filing, or nondischargeable debts like tax debt. You might have to give up some of the things you own. Chapter 13 uses a five-year repayment plan instead (three years if you're low income) to repay some of your debts within that plan. Once you complete a Chapter 13 plan, the court discharges your remaining eligible unsecured debt.
What is bankruptcy credit counseling?
You can't file a bankruptcy petition until you first complete credit counseling with an approved provider. When you finish the required session, you receive an authenticated certificate to file with the bankruptcy court. Pre-bankruptcy credit counseling covers your personal finances and bankruptcy alternatives. You might receive your counseling in person, by phone, or online. Sessions normally take an hour. Counseling typically costs a small fee. You can request a fee waiver if you can't afford it.
What is the difference between credit counseling, debt settlement, and bankruptcy?
Credit counseling is a form of assistance where someone helps you create a plan to deal with your debt problems, and that can include a debt management plan. In a DMP, a credit counseling agency works with your creditors to lower your interest rates and set up a three-to-five-year repayment plan, and you make one monthly payment to the agency instead of several to your creditors. Debt settlement is a negotiation with creditors to accept a reduced one-time payment instead of the full balance you owe. Bankruptcy is a court-ordered process that discharges some, and possibly not all, of your debts. You might have to give up some of what you own or agree to an aggressive repayment plan.
Can I keep my house if I file bankruptcy?
Possibly. Chapter 13 bankruptcy generally offers a better chance of keeping your home, since it gives you time to catch up on missed mortgage payments while making your regular payments. Chapter 7 doesn't include a repayment plan, so you could lose your home if you can't catch up on missed payments once your case closes. Bankruptcy also triggers an automatic stay, which pauses foreclosure while your case is open. This doesn't cancel the mortgage payments you owe.
Does bankruptcy stop debt collectors from contacting me?
Yes, in most cases the automatic stay stops debt collectors as soon as you file your petition. Once it's in effect, creditors and collectors must stop calls, letters, lawsuits, and wage garnishment for debts included in your case. The automatic stay doesn't cancel what you owe on secured debt like a mortgage or auto loan, so a lender could still ask the court for permission to resume collection if you fall behind on those payments during your case.
How long does bankruptcy take from start to finish?
Chapter 7 typically takes about four to six months from filing to discharge, since there's no repayment plan involved. Chapter 13 takes considerably longer, generally three to five years, because the process includes your full repayment plan. Both timelines assume your case goes smoothly. If you miss a required step, like your credit counseling course or your 341 meeting, either process could take longer.
Debt Relief
Debt Solutions
