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What is bankruptcy and how does it work?

At a glance:

  • What is bankruptcy?

  • Alternatives to bankruptcy

  • Types of personal bankruptcy

  • Chapter 7 bankruptcy

  • When Chapter 7 bankruptcy is best

  • Chapter 12 bankruptcy

  • Chapter 13 bankruptcy

  • Summary of bankruptcy and its alternatives

What is bankruptcy?

Bankruptcy refers to a federal code of laws and rules designed to help provide a fresh start to individual or business debtors facing more debt than they can afford to pay.

Bankruptcy permits the debtor to work out a more affordable plan to repay some or all of the debt, or to have some or all of the debt erased or "discharged." Both the "work-out" and debt discharge options are subject to strict rules and limitations, but bankruptcy gives debtors protections and benefits they would not otherwise have.

Most notably, bankruptcy may provide full or partial debt forgiveness and requires creditors to stop all collection efforts. Bankruptcy law requires the debtor to make full disclosure of all assets, liabilities and other financial information. The debtor must either surrender non-exempt assets (if any) for liquidation and distribution to creditors or formulate and follow through on a plan of reorganization and more manageable debt repayment.

Where they are adjudicated

Bankruptcy cases are adjudicated by the Bankruptcy Court, a federal court that is a unit of the U.S. District Court in your region. A bankruptcy case is commenced by the filing of a "bankruptcy petition," a formal request for relief under the bankruptcy laws.

The United States Trustee Program is a component of the Department of Justice. The U.S Trustee supervises the administration of bankruptcy cases and reports to the court. The Trustee's mission is to help promote the efficiency and protect the integrity of the bankruptcy system.

The U.S. Trustee monitors the conduct of all parties in bankruptcy cases, oversees related administrative functions, and acts to ensure compliance with applicable laws and procedures.

Alternatives to bankruptcy

Budgeting, belt-tightening and maybe new or supplemental employment form the basis of a successful effort to avoid bankruptcy. Begin with a budget – simply a list of all of your current income and expenses.

Be sure to prioritize all your expenses, listing those that are essential, like food and utility bills, as well as the highest-priority debt payments, e.g., secured loans (e.g., your mortgage and car payments).

Have some money to pay debts

It's easier said than done, but if you've decided to avoid bankruptcy, you'll obviously need some money left over each month to pay your debts after you've paid all your basic living expenses. That means finding ways to increase your income (e.g., delivering pizzas or newspapers) and/or reduce your spending on all but the necessities.

With a plan to bring in more money and cut costs, you'll be in a position to fashion a new budget – a specific, written agreement with yourself or your family. The new budget will include a workable monthly dollar amount that you can allocate to paying your creditors. Those payments will be the rope that allows you to start climbing out of the hole that debt has dug for you.

Contact your creditors

But the process is slow. Meanwhile, your creditors need to hear from you, so contact them and explain the situation. You will have more flexibility and time to deal with unsecured loans such as credit cards and medical bills. In fact, the card companies and medical providers may pleasantly surprise you with their willingness to work with you in setting up a realistic payment plan that may waive late fees.

After all, lawsuits are expensive – the option of last resort to most creditors. That's why there are private as well as federal programs that mortgage loan servicers participate in that can provide you with temporary relief. For more details, search for "Foreclosure Avoidance Counselors" at hud.gov. Student loan agencies, meanwhile, offer reduced payment options and forbearance programs while you work your way out of a squeeze.

A good credit counseling agency will be a non-profit operation, so the cost of their service is low or even nothing. (Photo: Getty Creative)
A good credit counseling agency will be a non-profit operation, so the cost of their service is low or even nothing. (Photo: Getty Creative)

Credit counseling agencies and debt negotiation

You've probably heard radio ads for credit counseling agencies or debt negotiation firms. Be aware that not all of these organizations are created equal, and there have been rampant scams involving "debt negotiators" that charge excessive fees or just take the consumer's money and do nothing. With that warning, however, consumers should know that the right credit counseling service can indeed provide information, guidance, and in some situations, debt management solutions. In fact, credit counseling from an approved agency is now a requirement for filing for bankruptcy.

Credit counseling services can be delivered online at reasonable cost and include basic education in money management and budgeting, as well as debt counseling. Perhaps the most valuable service offered by some credit counseling services is the debt management plan. As part of this customized plan, the counseling agency will negotiate an affordable monthly payment at a lower interest rate with credit card companies, for example. The consumer will make a single monthly payment to the agency, which then makes the agreed-upon payments to individual creditors.

A good credit counseling agency will be a non-profit operation, so the cost of their service is low or even nothing. Instead, the bulk of reputable credit counseling agency funding comes from the very creditors with whom the agency has negotiated. After all, it's in a creditor's interest to accept a lower payment on better terms from you, rather than having you eliminate the whole debt in bankruptcy.

For more information

Search for "credit counseling" at justice.gov. The U.S. Bankruptcy Trustee's Website is located there, and you can find a list of approved credit counseling agencies by state. You can also check the National Foundation for Credit Counseling at www.nfcc.org.

Types of personal bankruptcy

Bankruptcy is the state of insolvency.

Deciding whether to file for bankruptcy may be one of the most important decisions in your life. It is not an easy decision because:

  • Bankruptcy laws are complicated. Whether you should declare bankruptcy depends on complex federal and state bankruptcy laws. Determining how these laws fit into your personal financial circumstances is not always easy.

  • Filing for bankruptcy can be an expensive, emotional, and harsh process that will affect your life for years.

  • Bankruptcy attorneys, debt counselors, and loan consolidation officers all have a financial interest in what you decide. They only make money if they convince you to hire them.

Individuals filing for bankruptcy usually apply under one of two sections of the US bankruptcy code: Chapter 7 or Chapter 13. Bankruptcy generally protects persons from their creditors, but how it does this differs according to the section under which one applies. Chapter 7 is generally referred to as liquidation bankruptcy while Chapter 13 is based upon restructuring debt.

Chapter 7 bankruptcy

A plaque is displayed at the entrance of the U.S. District Bankruptcy Court for the Southern District of New York in Manhattan, New York. (Photo: REUTERS/Brendan McDermid)
A plaque is displayed at the entrance of the U.S. District Bankruptcy Court for the Southern District of New York in Manhattan, New York. (Photo: REUTERS/Brendan McDermid)

Chapter 7 is liquidation bankruptcy

Under a liquidation bankruptcy (Chapter 7), the bankruptcy court can discharge (wipe out) your debts. Under Chapter 13 (also called a reorganization bankruptcy), you file a plan with the bankruptcy court proposing how you will repay your creditors. Depending on what the court finds you can afford, some debts must be repaid in full, while others may be only partially repaid or completely discharged.

Under Chapter 7, all non-exempt assets are sold and the proceeds are used to pay off creditors. Exempt assets are defined by the federal and state bankruptcy laws. The purpose of bankruptcy is to avoid destitution of individuals or families.

Recent changes in the law have made it harder to file Chapter 7

Significant changes were made to the federal bankruptcy law in 2005, and it is now much more difficult to file under Chapter 7 than in the past. Under the new rules, you must compare your current monthly income to the median income for a household of your size in your state. If your income is at or below the median, you can file for Chapter 7.

The means test

If your income is greater than the median level, however, you must now pass a "means test" in order to file for Chapter 7. To pass the means test, certain allowed expenses and debt payments are subtracted from your current monthly income. If your remaining income is below a certain amount, you can file for Chapter 7. If it is above that amount, you are considered to have enough disposable income to make payments under a Chapter 13 reorganization plan.

Under either Chapter 7 or Chapter 13, the debtor is now required to participate in credit counseling by an approved provider.

When Chapter 7 bankruptcy is best

Chapter 7 may be the best bankruptcy option for anyone meeting one or more of the following situations:

  • Low income and/or high medical and living expenses

  • Minimal property

  • High level of unsecured consumer debt (e.g., credit card debt)

Important features of Chapter 7

If you qualify, Chapter 7 bankruptcy has some key features to note:

  • The process has a relatively short length of time; it is usually over in 120 days.

  • Unsecured debt can be eliminated (you never have to pay it back).

  • Secured debt cannot be eliminated, but it can be exempted and retained provided timely payments are made over the period of the bankruptcy. The amount that can be exempt varies from state to state.

Limits to what you can eliminate

Some debts cannot be eliminated, such as:

  • Most federal and state taxes

  • Debt created by fraud

  • Debts not listed by you in your filing papers

  • Debts arising from embezzlement or larceny or other illegal actions

  • Debts for child support, alimony and property settlements

  • Debts for liability for willful and malicious injury

  • Debts for fines and punishments

  • Debts for student loans

  • Debts for liability for driving while under the influence

  • Debts denied or waived in a Chapter 7 bankruptcy within the last eight years

One is limited to claiming Chapter 7 bankruptcy once every eight years. Chapter 7 is available to businesses as well as individuals, but we will focus on the latter. Under Chapter 7, a trustee is appointed to collect and sell all non-exempt property that is not secured (e.g., by a mortgage on your house), and to use any proceeds to pay creditors.

You can protect some property

The Bankruptcy Code allows an individual debtor to protect a certain relatively modest amount of property from the claims of creditors because it is exempt under federal bankruptcy law or under the laws of the debtor's home state. Since the determination of what property is exempt and which you may keep is often a question of state law, you should consult an attorney to advise you.

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Finding bankruptcy forms

Official bankruptcy forms may be purchased at legal stationery stores or downloaded from the U.S. Courts website here. They are not available from the court. As a practical matter, however, filing for and following through with a bankruptcy case is extremely difficult to accomplish without a lawyer who regularly handles bankruptcy.

What you must file

A Chapter 7 case begins with the debtor filing a petition with the U.S. Bankruptcy Court serving the area where the individual lives. In addition to the petition, the debtor must file:

  • Schedules of assets and liabilities

  • A schedule of current income and expenditures

  • A statement of financial affairs

  • A copy of his or her tax return for the most recent tax

  • A certificate of credit counseling

  • Evidence of any payments received 60 days before filing

  • A statement of monthly net income and any anticipated increase in income or expenses after filing

  • The court charges about $300 in filing fees, which can be waived in some cases

In order to fill out the official bankruptcy forms that make up the petition, statement of financial affairs, and the various schedules, the debtor must provide the following information:

  • A list of all creditors and the amount and nature of their claims

  • The source and amount of the debtor's income

  • A list of all of the debtor's property

  • A detailed list of the debtor's monthly living expenses

Married individuals must gather this information for their spouse regardless of whether they are filing a joint petition, separate individual petitions, or even if only one spouse is filing. In a situation where only one spouse files, the income and expenses of the non-filing spouse are required so that the court, the trustee and creditors can evaluate the household's financial position.

Filing a petition under Chapter 7 automatically "stays" (stops) most collection actions against the debtor. As long as the stay is in effect, creditors generally may not initiate or continue lawsuits, wage garnishments, or even telephone calls demanding payments. The bankruptcy clerk gives notice of the bankruptcy case to all creditors whose names and addresses are provided by the debtor.

What if you earn too much money?

If the debtor's "current monthly income" is more than the state median, the Bankruptcy Code requires application of a "means test" to determine whether the Chapter 7 filing should be dismissed. The "current monthly income" received by the debtor is the average monthly income received over the six months before the bankruptcy filing.

The individual Chapter 7 debtor hopes to and usually does receive a discharge, which means that he or she is relieved of the obligation to pay most unsecured debts. Debts not dischargeable include debts for alimony and child support, certain taxes, and debts for malicious injury by the debtor to another person.

Chapter 13 bankruptcy

Chapter 13 is the debt repayment chapter for individuals, including those who operate businesses as sole proprietorships, who have regular income, and whose debts do not exceed specified levels. A Chapter 13 bankruptcy is also called a "wage earner's" plan. A Chapter 13 case begins by filing a petition with the bankruptcy court serving the area where the debtor has a domicile or residence. The information required to be provided with the Chapter 13 petition is much the same as that for a Chapter 7 petition.

What Chapter 13 does

Chapter 13 generally permits individuals to keep their property by repaying creditors out of their future disposable income. The Chapter 13 debtor proposes a three-to-five-year repayment plan that must be approved by the Bankruptcy Court. During this time the law forbids creditors from starting or continuing collection efforts.

Instead, the debtor pays the amounts set forth in the plan to the Chapter 13 trustee, who distributes the funds to creditors in return for a small fee. The debtor may not incur new debt without consulting the trustee, because additional debt may compromise the debtor's ability to complete the plan. The Chapter 13 debtor receives a discharge of most debts after the debtor completes the payments required under the plan.

Advantages

Despite the fact that Chapter 13 does not provide for the complete discharge of debt in most Chapter 7 cases, Chapter 13 offers individuals a number of advantages over Chapter 7. Perhaps most significantly, Chapter 13 allows the individual a chance to save his or her home from foreclosure. Instead, by filing under this Chapter, individuals can stop foreclosure proceedings. Payments to the mortgage lender may be made over the original loan repayment schedule (which may be longer than the plan) as long as any arrearage is made up during the plan.

Likewise, Chapter 13 allows individuals to reschedule and possibly lower payments on secured debts in addition to the mortgage loan for their primary residence. Chapter 13 also has a special provision that protects third parties—e.g., loan co-signers—who are liable with the debtor on "consumer debts."

What the individual must do

In Chapter 13, the individual makes the plan payments to a trustee who then distributes payments to creditors according to the plan, which may offer creditors less than full payment on their claims. Individuals will have no direct contact with creditors while under Chapter 13 protection. Filing the petition under Chapter 13 automatically "stays" (stops) most collection actions against the debtor.

Three types of claims

There are three types of Chapter 13 creditor claims: priority (e.g., taxes), secured (e.g., a home mortgage loan) and unsecured (e.g., credit cards). The plan need not pay unsecured claims in full as long the plan provides that the debtor will pay all projected "disposable income" (as the law defines that term), and as long as unsecured creditors receive at least as much under the plan as they would receive if the debtor's assets were liquidated under Chapter 7.

Chapter 12 bankruptcy

Chapter 12 bankruptcy is similar to Chapter 13, but it is reserved for family farmers and fishermen who may be able to pay their debts with regular income received from their labors.

Summary of bankruptcy and its alternatives

During difficult times and with filings up, bankruptcy no longer carries the negative stigma it once did. Folks recognize it as an unfortunate fact of life as some of us need a "fresh start." Still, it is not a step to be taken lightly and there are ways to avoid it that should be explored in many situations.

When bankruptcy becomes inevitable, however, it is important to distinguish between the two primary forms for most ordinary debtors. If you qualify by virtue of your income level and assets, Chapter 7 provides for a complete discharge of most debts. For those who have regular income, Chapter 13 allows one to keep his or her property and work out a revised repayment plan.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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