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What is Bankruptcy & How to Avoid It
“I. Declare. Bankruptcyyyyyy!”
As Michael Scott learned in “The Office,” getting rid of debt isn’t as simple as that announcement. Wouldn’t that be nice?
Many people think of filing bankruptcy as an easy way out. But these people have never filed bankruptcy.
In reality, bankruptcy is a drastic measure for shoring up your finances and getting your debt under control when you’ve exhausted all other options. And it comes with consequences — mainly a serious hit to your credit.
But it can also be a lifeline. Bankruptcy creates an orderly, sanctioned plan that tells you who you have to pay back and how much. That sense of order alone can be a relief for anyone staring into a pile of past-due bills.
We’ll explain what happens when you file for bankruptcy, how it works, the different types of bankruptcy, pros and cons, as well as how to avoid it altogether in this guide.
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Bankruptcy is a legal process by which an individual, couple or corporation with significant debt is either relieved of that debt or allowed to pay it off under a specified plan.
That may sound really appealing if you’ve got debt up to your eyeballs, but realize that even after filing bankruptcy, you may still have to repay your debt.
While for some people, bankruptcy is better than having their wages garnished or their homes put into foreclosure, it should be a last resort for getting rid of debt.
But if you’re out of options, bankruptcy can give you a chance to get your debt under control and get creditors and collectors off your back (and out of your bank account).
And you wouldn’t be the first person to seek relief from financial burdens. The Bankruptcy Act of 1898 first introduced the concept of debtor relief to modern society in the United States. The modern Bankruptcy Code is based on the Bankruptcy Reform Act of 1978, which established Chapter 11 and Chapter 13 bankruptcies (more on that later).
Individuals and couples can file one of two types of bankruptcy.
Chapter 7 is the most common and is often referred to as liquidation bankruptcy. It’s for individuals who can prove they don’t have the income or means to pay off debts.
Filing for bankruptcy doesn’t mean you’ll lose everything you own. In fact, in most Chapter 7 bankruptcy cases, most of what is considered “reasonably necessary” to live and work is considered exempt. In many cases that can include your car and primary home.
Your 401(k), 403(b) and 457(b) plans are all considered protected assets, which means you do not have to use any of the money in those accounts to settle your bankruptcy debts.
However, if you’re way behind on your mortgage payments or already in the process of foreclosure, you could potentially lose your home. Or if you own a car that’s worth significant money (think $15,000 or more), the trustee might sell it to pay down your debt. The rules and exemptions vary from state to state.
There is no debt limit for Chapter 7, but your “means” to pay off your debt will be tested, and anyone who files for it is required to take credit counseling courses within six months of filing.
Most people can expect the process to take anywhere from three to six months.
Chapter 13 — or “wage-earner bankruptcy” — is for people whose income makes them ineligible for Chapter 7. Individuals and families who file Chapter 13 will work with a trustee to restructure and reorganize their debt and pay it back over three to five years. During this time frame, debtors are not allowed to take on any additional debt.
You won’t have to liquidate any assets in Chapter 13, meaning you can keep your house. Instead, your payment plan will be determined by your household income and how it compares to your state’s median income.
Chapter 13 bankruptcy does come with some debt limits. According to the Federal Judiciary, you can only have:
Federal law requires you to make your first payment to your trustee 30 days after filing.
The Federal Judiciary describes bankruptcy as it applies to businesses and less common types of bankruptcies. Here’s a basic overview:
*Debt limit, fees and requirements are accurate as of August 2024.
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The process is extremely complex, so don’t expect to go through it alone — and don’t expect it to be cheap. If you’re filing for Chapter 7 or Chapter 13, you’ll need to complete credit counseling from an approved agency first. For all forms of bankruptcy, you’ll want to start by gathering documentation of key financial documents such as tax returns, bank statements, credit card statements, lists of assets and debts.
Next, you’ll determine which chapter to file for based on your status (individual, couple or business) and debts. Then, you’ll file the petition with the bankruptcy court in your federal judicial district. There’s at least one in every state. The process is pretty involved, and you’ll want to consult with a bankruptcy attorney to make decisions for your individual case. As for fees, you can apply to have Chapter 7 fees waived (with this form) or set up a payment plan for Chapter 13 fees if you can’t afford them upfront. To be eligible for a waiver, your household income should be less than 150% of the poverty line (calculated for you here), and you have to be unable to pay the fee in installments.
Additionally, you’ll be responsible for legal fees, which will vary — but a few thousand dollars is not uncommon.
In most cases, this administrative process is carried out by a trustee appointed to your case.
The trustee helps you file paperwork and oversees your assets as well as the repayment plan, if applicable, during the case. They’re an impartial player who can challenge creditors’ claims or yours, based on conversations with both.
Then a bankruptcy judge decides whether to discharge your debts. The judge could deny you for a few reasons:
But in general, if you’re able to show your inability to repay debts, you should be granted a discharge. For Chapter 7 filings, debts are discharged within a few months after the liquidation of non-exempt assets. With Chapter 13, debts are discharged after the repayment plan is completed, which could take three to five years.
If they rule in your favor, you’re released from personal responsibility for your debts, and creditors can’t take any more action to collect them.
Debtors typically use bankruptcy to discharge credit card or medical debt. But many types of debt can’t be discharged, including:
For auto loans, your debt may be discharged, but it could mean the creditor can seize the property you took a loan against — they could repossess your car, for example.
You can instead choose to “reaffirm” the debt, or leave it out of the bankruptcy discharge, and you’ll remain responsible for paying it off. And you get to keep your property.
With Chapter 7 bankruptcy, your non-exempt assets may be sold by the trustee to pay back creditors. Non-exempt assets may be retained. For Chapter 13 bankruptcy, you can retain your assets due to the repayment plan based on your income and expenses. A Chapter 11 bankruptcy generally allows the debtor to retain their assets, but they may be sold to pay off debts.
Once you file bankruptcy, creditors and collectors have to stop trying to collect the money you owe them while the case is open. This is called an “automatic stay.”
If a company continues to try to collect during the stay, it’s violating a court order. Let the company know in writing, and the collections will likely stop. If they don’t, notify the bankruptcy court, which can punish the company for violating a court order.
As for unsecured debts, they are either discharged (Chapter 11) or repaid through a repayment plan (Chapter 13).
Bankruptcy will be a black mark on your credit history — one that lasts up to 10 years. The immediate impact is typically a significant drop, as the filing will be on your credit report. This will make it difficult to secure new credit in the future, especially credit with attractive interest rates or terms.
But if you’re in over your head with debt, your credit is probably already pretty marred.
Some experts say bankruptcy won’t hurt your credit much more than a poor payment history. Just make sure filing bankruptcy is really your best option, because the aftermath is not fun.
Here’s one woman’s story of what it feels like to declare bankruptcy and how she repaired her credit afterward.
If you’re considering filing for bankruptcy, take note of the pros and cons to help guide your decision:
Pros
Cons
The following alternatives to bankruptcy can provide relief from debt while avoiding some of the negative consequences of filing for bankruptcy.
Debt consolidation
With debt consolidation, you can combine multiple debts from different creditors into a single loan or credit line, typically with a lower interest rate.
Pros
Cons
Debt settlement
With debt settlement, you negotiate with creditors to play a lump sum or a reduced amount of your total debts. People often use a debt settlement agency to help with this process.
Pros
Cons
Credit counseling
Working with a certified credit counselor can help you develop a budget, stick to it and improve your financial health.
Pros
Cons
Besides pursuing debt consolidation, debt settlement and credit counseling, how can you avoid bankruptcy? Here are some best practices when improving your financial wellness:
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Not necessarily. Bankruptcy can discharge some or all of unsecured debts. Other types, like student loans, child support and tax obligations, are generally not dischargeable.
If you file for Chapter 7 bankruptcy, you may have your non-exempt assets sold to pay back creditors. However, essential items such as your primary residence may be exempt. With Chapter 13 bankruptcy, your primary residence can generally be retained provided you follow your repayment plan.
Remember when you’re filing: Bankruptcy is a legal action judged in federal court. So if you try to pull one over on your judge or trustee, expect some serious consequences. Here are some major no-nos:
If you’re caught doing any of these you could be fined, denied discharge or face criminal charges.
Yes, it is possible but there are time limits. For Chapter 7, you can file after eight years and for chapter 13, you can file again two years after the previous discharge. Multiple filings will have a major impact on your credit.
Dana Miranda is a former writer and editor at The Penny Hoarder.
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