Types of Bankruptcy
Officially, there are six types of bankruptcies – Chapters 7, 9, 11, 12, 13 and 15 – but 99% of bankruptcy cases filed in 2019 were Chapter 7 (liquidation) or Chapter 13 (personal reorganization).
The other four, Chapter 11 (business reorganization), Chapter 9 (municipalities); Chapter 12 (farmers) and Chapter 15 (cross border) make up the other 1%.
Some people refer to Chapter 7 bankruptcy as “liquidation bankruptcy’’ because it discharges most of your unsecured debt by liquidating your assets. Going away are unsecured debts like credit cards, personal loans and medical bills.
It’s the quickest, simplest and most common type of bankruptcy, but first, you must qualify.
To qualify for Chapter 7 bankruptcy, you must pass Part 1 or Part 2 of your state’s means test. Part 1 has to do with income. If your household income is less than your state’s median income, you qualify. Remember that median income means half the people in the state have more income, half have less. If you have less, you qualify for Chapter 7.
If you have more than the median income, there is still a chance to qualify through Part 2 of the “means” test. In Part 2, you must document all your allowable expenses for the previous six months (rent, food, transportation, clothing, medical expenses, etc.) and subtract that from your income.
What’s left is called “disposable income” that can be applied to debt. If you’re disposable income is low enough, compared to your debt obligations, you may qualify for Chapter 7.
If you qualify for Chapter 7, it means the court trustee will sell non-exempt assets to pay off creditors. The definition of non-exempt assets varies from state-to-state, but just about anything that has value could be included. That means a nice car or home that has some equity, jewelry, art or stamp collections, musical instruments, electronic devices, etc.
The whole process for Chapter 7 can be completed in 6-8 months.
Chapter 13 bankruptcy is also known as “reorganization bankruptcy.’’ You offer the judge a repayment plan that allows you to pay back creditors in 3-5 years. No property is required to be liquidated. For Chapter 13 bankruptcy, you must have regular income to make the required monthly payments.
There also are debt limit qualifications for Chapter 13 that you can’t exceed. You must have less than $394,725 in unsecured debt or less than $1.184 million in secured debt.
You will make monthly payments on your debts for 3-5 years and can’t take out any loans during that time. If you fail to make the payments, you likely will be back in court and your discharge rescinded.
Chapter 11 bankruptcy is somewhat similar to Chapter 13, but it’s typically reserved for businesses. Essentially, it’s a reorganization or restructuring of the company. It’s possible for businesses to file for Chapter 7 bankruptcy, but that means a liquidation of assets, so Chapter 11 is a more attractive option. That allows businesses to maintain their assets and continue operations, but they must devise a plan to pay off some of their debt or get it forgiven.
What Is a Discharge?
A discharge is a court order that releases you from obligations to pay debts. It means that creditors or debt collectors must stop attempts to collect on the debts. That means no more harassing phone calls and filling your mailbox with threatening letters. In other words, discharge is your get out debt card.
Which Debts Are Discharged in Personal Bankruptcy?
Bankruptcy allows you to discharge debts in the following categories:
Which Debts Are Not Discharged in Bankruptcy?
The following debts are not forgiven in personal bankruptcy:
- Tax debt (although some IRS debt could be eligible for a payment plan)
- Child support
- Student loans
If you have luxury item purchases or cash advances received immediately prior to the bankruptcy filing, creditors can challenge that, saying these were premeditated transactions, and have them excluded.
Another consideration: A bankruptcy discharge is personal and protects you. But it does not eliminate the debt itself. For example, if you had a co-signer on a home loan and you file for bankruptcy, the lender can still seek to collect the debt from the person who co-signed the loan. This is important to remember if you have family members or friends co-sign a loan, but are not going to file for bankruptcy.
What Are Potential Effects of a Discharge?
The immediate effect of a bankruptcy discharge is that your credit score will plummet and a notation will be added to your credit report saying you failed to pay your debts as agreed. That will stay on your credit report for 7-10 years.
How far your credit score plunges depends on where you stood at the time of the discharge. If you were above 700, for example, figure on a 100 to 150-point drop. If you were at 600, it’s more likely to be 75-100 point drop.
Reaffirming a Debt
Reaffirming debt means that you sign, and file with the court a legally enforceable document, which states that you promise to repay all or a portion of a debt that may otherwise have been discharged in your bankruptcy case. Reaffirmation agreements must generally be filed with the court within 60 days after the first meeting of creditors. Reaffirmation agreements are strictly voluntary — they are not required by the Bankruptcy Code or other state or federal law.
What Are the Effects of Reaffirming a Debt?
If you reaffirm a debt and fail to make the payments required in the reaffirmation agreement, the creditor can take action against you to recover any property that was given as security for the loan and you may remain personally liable for any remaining debt.
You can voluntarily repay any debt instead of signing a reaffirmation agreement. Reaffirmation agreements must not impose an undue burden on you or your dependents and must be in your best interest. If you decide to sign a reaffirmation agreement, you may cancel it any time before the court issues your discharge order or within sixty (60) days after the reaffirmation agreement was filed with the court, whichever is later
Cost of Bankruptcy
Though your finances may be in bad shape, filing for bankruptcy can still cost you a significant amount of money. Retaining a bankruptcy attorney could cost you several thousand dollars.
If you prepare and file your own bankruptcy case, the filing fees alone are substantial and your chances of success are greatly reduced.
According to the National Bankruptcy Forum, the average cost of a Chapter 7 bankruptcy is $1,250.
Bankruptcy on Your Credit Report
Chapter 7 bankruptcies will remain on your credit report for 10 years. Chapter 13 bankruptcies remain on your credit report for seven years.
As part of any bankruptcy filing, there’s a required educational process.
Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, consumers must undergo pre-file credit counseling 180 days before filing for bankruptcy. The counseling provides education about the process and alternative debt-relief options.
After filing, consumers must complete a pre-discharge course (mandatory to have your debts discharged) about personal financial management. It’s designed to prevent additional and future financial difficulties. It will provide structure for managing your money, creating and maintaining a budget, and using credit appropriately.
Should I Declare Bankruptcy?
There is a reason bankruptcy is called the “nuclear option” for debt relief. It should only be considered if you already have tried – and failed – to make a dent in your debt obligations using other debt-relief options.
If that’s the case, consider the pros and cons before deciding to push the button.
Pros of Bankruptcy
- Eliminates or reduces debt for people in dire financial situations, perhaps due to illness or loss of a job.
- Temporarily prohibits creditors from foreclosing on a home or repossessing a car.
- Temporarily prevents wage garnishment, debt collectors’ harassment or disconnection of utilities.
- Allows consumer to get a “second chance” with their finances.
Cons of Bankruptcy
- Affects credit record for up to 10 years, creating problems in obtaining loans for cars, homes.
- Becomes a public record that can be viewed by potential employers, insurance companies, banks and other lenders.
- It will be extremely difficult to get a mortgage after bankruptcy. You may not qualify for loans for several years, especially mortgage or home equity loans. And if you get loans, the interest rates will be higher because of the risk.