What is Bankruptcy and How Does It Work?

Maybe you were socked with an unexpected and uninsured medical expense, and you didn’t have the savings to cover the bills. Perhaps you lost your job and can no longer juggle your car and mortgage payments. Maybe you dipped into personal assets in a desperate (and futile) bid to salvage your business. 

Perchance your husband split and left you holding a big bag of joint debts. Or you bought into the easy-credit, instant-gratification, shop-till-you-drop mentality encouraged by lenders and retailers and found yourself mired in financial quicksand. In any case, things got out of hand and now you’re up to your ears in debt.

Finance companies are warning that if you don’t pay up, soon, they’ll take your home and car. Credit card firms are threatening to haul you into court. Debt collectors are pursuing you relentlessly. Your finances are a disaster. Your personal and professional relationships are strained. You’re losing sleep, and you’re becoming a perfect candidate for ulcers. Welcome to the club. Millions of Americans are in the same leaky boat.

Thankfully, you have a perfectly legitimate way to stop foreclosures and repossessions, put an end to lawsuits, protect your paycheck from garnishments, get those menacing debt collectors off your back, and regain control of your life: bankruptcy. 

Bankruptcy is shrouded in myth and prejudice. If you’re like many folks, the first step on the road to financial recovery is overcoming your feelings of inadequacy, shame, guilt, and fear of the unknown. 

In this article, we encourage you to put aside myth and prejudice and look calmly at the advantages and disadvantages of bankruptcy. Only then can you make a rational decision about whether bankruptcy is the best choice for you and your loved ones.

Understanding Bankruptcy

The bankruptcy process offers an individual or company a chance to make a fresh start by discharging debts that cannot be discharged while providing creditors with some measure of repayment based on assets available for liquidation. In theory, bankruptcy benefits the overall economy by providing credit to people and businesses and a portion of debt repayment to creditors. If the bankruptcy process is successful, the debtor is discharged from obligations incurred prior to filing for bankruptcy.

All bankruptcy cases in the United States are handled by federal courts. Judges decide whether a debtor is eligible to file for bankruptcy and whether debts are discharged in federal bankruptcy cases. Trustees are usually appointed by the United States Trustee Program of the Department of Justice to administer bankruptcy cases on behalf of debtors’ estates.

Unless a creditor objects, the debtor generally has little direct contact with the judge.

Types of Bankruptcy Filings

Consumer bankruptcies are covered mainly under two parts of the U.S. Bankruptcy Code:

  • Chapter 7 liquidation enables you to eliminate most of your debts but may require you to forfeit some of your assets for distribution to creditors.
  •  Chapter 13 reorganization enables you to pay off all or a portion of your debts during a three- to five-year time span but doesn’t require you to forfeit any of your belongings or assets to pay unsecured debts (debts that are not secured by property, such as your car or another valuable asset).

Likewise, other special kinds of bankruptcy exist. Chapter 11 bankruptcy is available to individuals but primarily applies to large business reorganizations. Chapter 12 bankruptcy, which is similar to Chapter 13 bankruptcy, addresses the unique problems family farmers and family fishermen face. As a practical matter, almost all consumer cases are covered under Chapter 7 or Chapter 13 of the code.

Liquidations (Chapter 7)

Chapter 7, commonly referred to as straight bankruptcy, is often what people mean or think of when they use or hear the term generically. In its simplest form, Chapter 7 wipes out most of your debts; in return, you may have to surrender some of your property. Chapter 7 doesn’t include a repayment plan. Your debts are simply eliminated forever. 

If you buy a lottery ticket the day after filing and hit the jackpot, yippee for you and tough beans for your creditors! You obviously can voluntarily pay back your creditors if you suddenly strike it rich, but, legally, you don’t owe a dime after your debt is discharged. 

Most property you receive after filing Chapter 7 doesn’t become part of your bankruptcy, but a few exceptions exist. Income tax refunds for prebankruptcy tax years go to pay your debts, as do divorce property awards, inheritances, and life insurance that you become entitled to receive within 180 days of bankruptcy. 

Theoretically, a debtor’s assets can be seized and sold for the benefit of creditors. All non-exempt assets owned on the petition date are fair game. They can be sold, with the proceeds distributed to your creditors. 

But in practice, 96 percent of consumer bankruptcies are no-asset cases, meaning that no property is taken away from the debtor because it’s all exempt or worth so little that it’s not worth the trouble.

To qualify for Chapter 7, if you earn more than the median income for your state, you must pass a new means test, in which you show that you don’t have enough income to pay a significant portion of your debts. Although the test is ungodlily complicated, when all is said and done, just about everyone can pass. The toughest part is just assembling the information you have to provide.

Consumer reorganizations (Chapter 13)

Chapter 13 involves a repayment plan in which you pay all or part of your debts during a three- to five-year period. In a Chapter 13 bankruptcy, you propose a debt-repayment plan that requires court approval and thereafter keeps creditors at bay as long as you keep making payments. 

This plan can be a great relief when you’re able to establish and live within the confines of a budget. A budget plan that demands frugality to the point of misery is doomed to fail (“Frugality is misery in disguise,” observed Pubilius Syrus some 2,000 years ago). One that is reasonable has a good chance of succeeding. The operative word, however, is reasonable.

Every Chapter 13 plan must pass two tests:

  • The best-interest test, which mandates that unsecured creditors be paid at least as much as they would receive if you filed a Chapter 7 instead of a Chapter 13.
  • The best-efforts test, which requires that you pay all your disposable income (the amount left over after paying reasonable living expenses) to the trustee for at least the first 36 months of your plan. If your monthly income is more than the median for your state, allowable expenses will be based on Internal Revenue Collection Financial Standards, and the plan must run for five years. Otherwise, the amount of your payment will be based on your actual expenses, as long as they are reasonable.

When you’re done, you’re done. Most creditors have gotten all they’re going to get. Life goes on.

Bankruptcy Facts and Myths

Bankruptcy is an economic decision, not a morality play, and you needn’t be deceived into viewing it as anything else. The following sections look at some of the usual myths that are cast about by the credit industry.

1. “People who go bankrupt are sleazy deadbeats”

Who are those people filing for bankruptcy? Chances are, they’re your neighbors, regardless of what neighborhood you live in. Bankruptcy is an equal-opportunity phenomenon that strikes in every socioeconomic bracket.

The fastest-growing group of bankruptcy filers is older Americans. More than half of people 65 and older who are forced into bankruptcy are forced because of medical debts. Also, more families with children, single mothers, and single fathers are being driven into bankruptcy; the presence of children in a household triples the odds that the head of the household will end up in bankruptcy. In any case, the image of the sleazy, deadbeat bankruptcy filer is a phantom and a scapegoat for irresponsible lending. 

The bankruptcy filer can be more accurately described as an ordinary, honest, hardworking, middle-class consumer who fell for aggressive and sophisticated credit marketing techniques, lost control, and unwittingly surrendered his financial soul to the devil that is debt.

2. “Bankruptcy is the easy way out for folks who can pay their bills”

Creditors have been making this claim since the 1800s, and it’s as demonstrably wrong today as it was back then. 

In recent years, the credit industry-funded several studies — a handy euphemism for propaganda, the more accurate description — that supposedly support their argument that people are skipping to bankruptcy court to skip out of their obligations. Independent sources have debunked every one of these self-serving reports. 

Two financial arms of Congress, the General Accounting Office and the Congressional Budget Office, discredited several of these studies. Bankruptcy isn’t the cause of debt; it’s the result. And it isn’t the disease; it’s the cure. Restricting access to bankruptcy court won’t solve the problem of debt any more than closing the hospitals will cure a plague.

3. “Honest folks pay a ‘tax’ to support people who are bankrupt”

Claiming that honest taxpayers are supporting people who are bankrupt is nothing short of an outright, bald-faced lie. 

The theory, trumpeted in press releases, is that hundreds of thousands of Americans routinely ignore their obligations, intentionally or recklessly drive up their debts, and then declare themselves insolvent, stiffing creditors and, ultimately, every God-fearing, bill-paying, hard-working, patriotic American. 

Creditors note that they write off billions every year. Thus, the reasoning goes, that if access to bankruptcy were restricted, the credit industry wouldn’t suffer losses that it must pass along to consumers. So, they say, BARF is good for consumers. 

They’re not saying that they’ll pass along any savings to their customers, though, and, historically, that has not been their practice. Besides, do you really believe that the credit industry paid politicians tens of millions of dollars to enact BARF in order to save you money? Not likely.

Advantages of Bankruptcy

If you have no way to pay your bills, you certainly need to consider bankruptcy. If you have an income but cannot repay your debts in full within three years while maintaining a reasonable standard of living, bankruptcy may be a wise option. Bankruptcy can

  • Halt almost every kind of lawsuit.
  • Prevent garnishment of any wages you earn after filing.
  • Stop most evictions if bankruptcy is filed before a state court enters a judgment for possession.
  • Avert repossessions.
  • Stop foreclosures.
  • Prevent your driver’s license from being yanked for unpaid fines or
  • judgments. (The stay doesn’t prevent revocation or suspension of your driver’s license for failing to pay court-ordered support.)
  • Bring IRS seizures to a skidding stop.

Bankruptcy generally doesn’t prevent

  • Criminal prosecutions.
  • Proceedings against someone who cosigned your loan, unless you file a
  • Chapter 13 repayment plan and propose paying the loan in full.
  • Contempt of court hearings.
  • Actions to collect back child support or alimony unless you file Chapter 13 and propose to pay off that obligation during the life of your plan.
  • Governmental regulatory proceedings.

Following is a deeper look at the benefits of bankruptcy:

1. Stopping creditors in their tracks

The moment that you file a bankruptcy petition, a legal shield called the automatic stay kicks in, prohibiting creditors from contacting you, suing you, repossessing your property, or garnishing your wages. 

After you file, a creditor can ask for permission to proceed with a repossession or foreclosure. But the creditor must obtain permission in advance, and the bankruptcy court judge may well turn down the creditor if you propose a reasonable plan for paying that particular debt. 

Whenever a creditor is foolish enough to ignore the automatic stay, he’ll have a federal judge on his back and may get zapped with a fine and an order to pay your attorney fees.

2. Wiping out most of your debts

Bankruptcy wipes out or discharges most debts. Credit cards, medical bills, phone charges, loans, and judgments all are usually dischargeable. However, some obligations generally are not eliminated in bankruptcy. These nondischargeable debts include the following:

  • Student loans
  • Alimony and child support
  • Damages for a personal injury you caused while driving illegally under the influence of drugs or alcohol
  • Debts from fraud
  • Financial obligations imposed as part of a criminal conviction
  • Taxes arising during the past three years

3. Catching up on back mortgage and car payments

Sometimes even dischargeable debts continue to haunt you when they’re tied to one of your essential possessions. For example, you can wipe out loans secured by your home or car, but the creditor can still foreclose on your house or repossess your vehicle if you don’t pay. 

In a Chapter 13 bankruptcy (one in which you pay what you can toward your debts and the remainder is forgiven), you can propose a partial-repayment plan to avoid foreclosure and make up back mortgage payments over a five- year span. 

You can prevent repossession of your car by catching up on back payments over the life of the plan. In some situations, you have to pay only what the vehicle is worth instead of the whole loan balance.

4. Filing bankruptcy to pay some debts over time

Although some debts are not dischargeable, filing a Chapter 13 reorganization enables you to pay debts such as support obligations or back taxes over a five-year period and protects you from being hassled while you’re paying down the balances. You can also gradually catch up on missed mortgage payments. In the meantime, most of your other debts are eliminated while you just pay for current expenses and keep current on the future house and car payments.

Disadvantages of Bankruptcy

Although bankruptcy may be that miracle cure you sought for your financial woes, you may encounter some unpleasant side effects. Consider the disadvantages of filing bankruptcy:

1. You can lose assets

Depending on how much your home is worth and where you live, it is possible but unlikely, that you’ll lose it by filing bankruptcy. In most bankruptcies, debtors don’t have to give up any of their belongings.

2. Bankruptcy is a matter of public record

As more records are stored on computers and accessible on the Internet, searching that data becomes easier for anyone who’s interested. In other words, if your nosy neighbor wants to know whether you filed bankruptcy, how much you owe, and who you owe it to, the information may be just a few mouse clicks away.

3. Bankruptcy affects your credit rating

Bankruptcy may have a negative effect on your credit rating, but that fact may well fall into the “So what?” category for you. Even with a bankruptcy on your record, your odds of obtaining credit are very good. With a little work and perseverance, you can reestablish credit almost immediately. 

Some credit card companies actually target folks right after bankruptcy because they know that these people are free of all their existing debts and probably won’t be eligible to file another bankruptcy any time soon. 

For a few years after bankruptcy, you may have to pay higher interest rates on new credit, but this result will ease over time, even if your credit report still shows bankruptcy. So don’t pay too much attention to the horror stories bill collectors tell you about the disastrous effect bankruptcy has on your credit.

4. Friends and relatives can be forced to give back money or property. 

If you repaid loans to friends or relatives or gave them anything within the past year, they can be forced to repay a trustee the money they received, if you don’t know what to watch out for. You can usually avoid these kinds of problems by carefully timing your bankruptcy filing.

Therefore, bankruptcy can strain relations with loved ones, especially parents who were raised in a different era.

5. You can suffer some discrimination

Although governmental agencies and employers aren’t supposed to discriminate against you for filing bankruptcy, they may still do so in a roundabout way. Prospective employers may also refuse to hire you.

This drawback is especially true in small communities, but it is much less likely to be a problem in cities, where newspapers rarely bother printing the names of non-business bankruptcies.

Alternatives to Bankruptcy

Bankruptcy isn’t for everyone, and sometimes better solutions are available. If it appears that the negatives outweigh the positives, another route may be your best choice. Depending on your situation, one of these options may be the best alternative:

  • Selling assets to pay debts in full
  • Negotiating with creditors to reduce your debts to a manageable level
  • Restructuring your home mortgage
  • Taking out a home equity loan
  • Doing nothing if you have nothing, expect to acquire nothing, and don’t care about your present or future credit rating

In any event, weigh your decision on a simple, rational scale. Ask yourself whether the benefits outweigh the drawbacks. Many people, ravaged by guilt and shame, think they need to fully exhaust every alternative before considering bankruptcy, including the following:

  • Making payments that never reduce the principal balance owed
  • Taking out second mortgages to pay credit card debts
  • Borrowing against pensions
  • Withdrawing funds from retirement accounts
  • Obtaining loans from friends and relatives
  • Taking second jobs (learn more about the best work from home jobs)

Think seriously about the strain your financial distress places on your health, marriage, and family. Granted, bankruptcy is a very serious step that you shouldn’t take lightly, but that doesn’t mean you have to wait until you’ve lost everything. Think of it in these terms: If you have some blocked arteries, it just may be smarter to have bypass surgery before you have a heart attack. The same is true of bankruptcy. Think of bankruptcy as preventive medicine.

Weighing The Consequences of Not Filing Bankruptcy

In the same way, that filing bankruptcy can have negative consequences, not filing can also have negative consequences. If you’re eligible for bankruptcy but opt against filing, creditors have a number of options they can pursue, depending on whether a particular debt is secured by your property.

1. Claims secured by your car

If your car secures a debt, the creditor can repossess the vehicle and sell it to cover the loan. The proceeds of a repossession sale usually aren’t enough to pay the debt, so you’ll lose the car and still have to pay the balance that you owe on it — the worst of both worlds. Although the law requires a creditor to sell a car in a “commercially reasonable” manner, that doesn’t necessarily mean that the creditor will receive nearly as much as you can by selling it yourself. 

Before allowing repossession, you may want to try selling the vehicle. Your chances of getting more money for the car are greater than the finance company’s. If you and your lawyer agree that it’s best to get rid of the car because you just can’t afford it, you can voluntarily surrender it to the lender instead of waiting for them to repossess it. 

Despite what people may tell you, your credit report will not look that much better, but at least you’ll avoid the hassle of finding your car gone when you come out of the supermarket, or the embarrassment of a tow truck showing up at your house.

2. Claims secured by your home

Mortgage companies can’t simply boot you out of your home and onto your der- rière if you miss a few payments. They must first go through a foreclosure procedure to extinguish your ownership rights. Although not all foreclosures involve court proceedings, all do take time — at least three months, in most cases, and frequently much longer. You can continue to live on the property until the foreclosure is completed.

3. Student loans

Government agencies can garnish (siphon off) up to 10 percent of your dis- posable income without going to court. A garnishment is almost like a withholding tax — the money is gone from your paycheck before you ever see it. You also need to be aware that Congress canceled state statutes of limitations on student loans. In other words, you can’t just wait it out. You must deal with student loans. They won’t disappear on their own.

4. Support obligations

Although debtors’ prisons are officially a thing of the past, a divorce court can still send you to jail for neglecting your support obligations, and some states have programs to revoke professional licenses — such as licenses for practical nurses or accountants or cosmetologists — of people who haven’t kept up with their support.

5. Fines and restitution

If you’ve been ordered to pay a fine or make restitution in connection with a criminal proceeding and don’t pay, accommodations at the local jail may await you. Don’t tempt the judge; some of them don’t need much tempting to have you hauled off in handcuffs.

6. Taxes

The IRS has truly scary powers to seize your bank account, your pension, real property, or even the shirt off your back. State taxing authorities also have similar special powers. In addition, your town or city, your student loan creditors, or your ex-spouse or kids may be able to grab your tax refund whenever you owe alimony or support.

7. Lawsuits

Creditors with other types of claims can’t do much without first suing you and obtaining a judgment. To do this, they must serve you with legal documents and give you a chance to dispute the debt in court. If you don’t respond, a default judgment can be entered against you. That means the ruling goes against you even though you never presented your case.

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