Bankruptcy is a legal process overseen by federal bankruptcy courts. It's designed to help individuals and businesses eliminate all or part of their debt or to help them repay a portion of what they owe.
Bankruptcy may help you get relief from your debt, but it's important to understand that declaring bankruptcy has a serious, long-term effect on your credit. Bankruptcy will remain on your credit report for 7-10 years, affecting your ability to open credit card accounts and get approved for loans with favorable rates.
Bankruptcy can be a complex process, and the average person probably isn't equipped to go through it alone. Working with a bankruptcy attorney can help ensure your bankruptcy goes as smoothly as possible and complies with all the applicable rules and regulations governing bankruptcy proceedings.
You'll also have to meet some requirements before you can file for bankruptcy. You'll need to demonstrate you can't repay your debts and also complete credit counseling with a government-approved credit counselor. The counselor will help you assess your finances, discuss possible alternatives to bankruptcy, and help you create a personal budget plan.
If you decide to move forward with bankruptcy proceedings, you'll have to decide which type you'll file: Chapter 7 or Chapter 13. Both types of bankruptcy can help you eliminate unsecured debt (such as credit cards), halt a foreclosure or repossession, and stop wage garnishments, utility shut-offs and debt collection actions. With both types, you'll be expected to pay your own court costs and attorney fees. However, the two types of bankruptcy relieve debt in different ways.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy, also known as "straight bankruptcy," is what most people probably think of when they're considering filing for bankruptcy.
Under this type of bankruptcy, you'll be required to allow a federal court trustee to supervise the sale of any assets that aren't exempt (cars, work-related tools and basic household furnishings may be exempt). Money from the sale goes toward paying your creditors. The balance of what you owe is eliminated after the bankruptcy is discharged. Chapter 7 bankruptcy can't get you out of certain kinds of debts. You'll still have to pay court-ordered alimony and child support, taxes, and student loans.
The consequences of a Chapter 7 bankruptcy are significant: you will likely lose property, and the negative bankruptcy information will remain on your credit report for ten years after the filing date. Should you get into debt again, you won't be able to file again for bankruptcy under this chapter for eight years.
Chapter 13 Bankruptcy
Chapter 13 bankruptcy works slightly differently, allowing you to keep your property in exchange for partially or completely repaying your debt. The bankruptcy court and your attorney will negotiate a three- to five-year repayment plan. Depending on what's negotiated, you may agree to repay all or part of your debt during that time period. When you've completed the agreed repayment plan, your debt is discharged, even if you only repaid part of the amount you originally owed.
While any type of bankruptcy negatively affects your credit, a Chapter 13 may be a more favorable option. Because you repay some (or all) of your debt, you may be able to retain some assets. What's more, a Chapter 13 bankruptcy will cycle off your credit report after seven years, and you could file again under this chapter in as little as two years.
Bankruptcy Terms to Know
Throughout bankruptcy proceedings, you'll likely come across some legal terms particular to bankruptcy proceedings that you'll need to know. Here are some of the most common and important ones:
- Bankruptcy trustee: This is the person or corporation, appointed by the bankruptcy court, to act on behalf of the creditors. He or she reviews the debtor's petition, liquidates property under Chapter 7 filings, and distributes the proceeds to creditors. In Chapter 13 filings, the trustee also oversees the debtor's repayment plan, receives payments from the debtor and disburses the money to creditors.
- Credit counseling: Before you'll be allowed to file for bankruptcy, you'll need to meet either individually or in a group with a nonprofit budget and credit counseling agency. Once you've filed, you'll also be required to complete a course in personal financial management before the bankruptcy can be discharged. Under certain circumstances, both requirements could be waived.
- Discharged bankruptcy: When bankruptcy proceedings are complete, the bankruptcy is considered "discharged." Under Chapter 7, this occurs after your assets have been sold and creditors paid. Under Chapter 13, it occurs when you've completed your repayment plan.
- Exempt property: Although both types of bankruptcy may require you to sell assets to help repay creditors, some types of property may be exempt from sale. State law determines what a debtor may be allowed to keep, but generally items like work tools, a personal vehicle or equity in a primary residence may be exempted.
- Lien: A legal action that allows a creditor to take, hold and sell a debtor's real estate for security or repayment of a debt.
- Liquidation: The sale of a debtor's non-exempt property. The sale turns assets into a "liquid" form — cash — which is then disbursed to creditors.
- Means test: The Bankruptcy Code requires people who want to file Chapter 7 bankruptcy to demonstrate that they do not have the means to repay their debts. The requirement is intended to curtail abuse of the bankruptcy code. The test takes into account information such as income, assets, expenses and unsecured debt. If a debtor fails to pass the means test, their Chapter 7 bankruptcy may either be dismissed or converted into a Chapter 13 proceeding.
- Reaffirmed account: Under Chapter 7 bankruptcy, you may agree to continue paying a debt that could be discharged in the proceedings. Reaffirming the account — and your commitment to pay the debt — is usually done to allow a debtor to keep a piece of collateral, such as a car, that would otherwise be seized as part of the bankruptcy proceedings.
- Secured debt: Debt backed by reclaimable property. For example, your mortgage is backed by your home, and for an auto loan, the vehicle itself is the collateral. Creditors of secured debt have the right to seize the collateral if you default on the loan.
- Unsecured debt: A debt for which the creditor holds no tangible collateral, such as credit cards.
Debt That Can't Be Forgiven
While bankruptcy can eliminate a lot of debt, it can't wipe the slate completely clean if you have certain types of unforgivable debt. Types of debt that bankruptcy can't eliminate include:
- Most student loan debt (although some members of Congress are working to change this).
- Court-ordered alimony.
- Court-ordered child support.
- Reaffirmed debt.
- A federal tax lien for taxes owed to the U.S. government.
- Government fines or penalties.
- Court fines and penalties.
Consequences of Bankruptcy
Perhaps the most well-known consequence of bankruptcy is the loss of property. As previously noted, both types of bankruptcy proceedings can require you to give up possessions for sale in order to repay creditors. Under certain circumstances, bankruptcy can mean losing real estate, vehicles, jewelry, antique furnishings and other types of possessions.
Your bankruptcy can also affect others financially. For example, if your parents co-signed an auto loan for you, they could still be held responsible for at least some of that debt if you file for bankruptcy.
Finally, bankruptcy damages your credit. Bankruptcies are considered negative information on your credit report, and can affect how future lenders view you. Seeing a bankruptcy on your credit file may prompt creditors to decline extending you credit or to offer you higher interest rates and less favorable terms if they do decide to give you credit.
Depending on the type of bankruptcy you file, the negative information can appear on your credit report for up to a decade. Discharged accounts will have their status updated to reflect that they've been discharged, and this information will also appear on your credit report. Negative information on a credit report is a factor that can harm your credit score.
Getting a Credit Card or Loan after Bankruptcy
Bankruptcy information on your credit report may make it very difficult to get additional credit after the bankruptcy is discharged — at least until the information cycles off your credit report. Lenders will be cautious about giving you additional credit, and they may ask you to accept a higher interest rate or less favorable terms in order to extend you credit.
It will be important to begin rebuilding your credit right away, making sure you pay all your bills on time. You'll also want to be careful not to fall back into any negative habits that contributed to your debt problems in the first place.
Getting a Mortgage After Bankruptcy
Just as bankruptcy can hinder your ability to obtain unsecured credit, it can make it difficult to get a mortgage, as well. You may find lenders decline your mortgage application, and those that do accept it may offer you a much higher interest rate and fees. You may be asked to put up a much higher down payment or shoulder higher closing costs.
Rather than give up your home and try to get a new mortgage after bankruptcy, it may be better to reaffirm your current mortgage during bankruptcy proceedings. You would be able to keep your home, continue paying on your current mortgage — free of other debts — and stay in your current home.
When you're struggling with unmanageable debt, bankruptcy is just one solution; there are others to consider. Most will also affect your credit, but probably not as badly as a bankruptcy — plus, these alternatives can allow you to keep your property, rather than having to liquidate it in bankruptcy proceedings.
Some bankruptcy alternatives you might consider are:
- Seek help from a government-approved credit counselor or debt management plan. A counselor can work with your creditors to help arrange a workable plan for repaying what you owe.
- Take out a debt consolidation loan. These types of loans can aggregate multiple high-interest, costlier debt into a single, lower-interest loan. Research debt consolidation loans to see if consolidation can lower the total amount you pay and make your debt more manageable.
- Approach your creditors and see if they're willing to agree to a more manageable repayment plan. Defaulting on your debt is not something your creditors want to see happen to you, either, so they may be willing to work with you to arrange a more achievable repayment plan. Settling your debt will have a negative effect on your credit scores.
Be aware that whenever you fail to honor the debt-repayment terms you originally agreed to, it can affect your credit. That said, bankruptcy will still have a more significant negative impact on your credit than will credit negotiation, credit counseling and debt consolidation.
A Last Word About Debt Relief
Whenever you fail to repay a debt as you originally agreed to, it can negatively affect your credit. Some types of debt relief come with consequences that are more damaging and long-term than others. Before you make any decision about debt relief, such as declaring bankruptcy, it's important to research your options, get reliable advice from a qualified credit counselor, and understand the impact your choices can have on your overall financial well-being.
Regardless of what type of debt relief you choose, you can begin taking better care of your credit immediately by putting simple, responsible, credit-positive actions into practice such as:
- Paying all your bills on time.
- Avoiding taking on additional debt.
- Monitoring your credit report.
- Creating and sticking to a personal budget.
- Using credit in small ways (such as a secured credit card) and paying the balances in full, right away.