If a person or business cannot pay back their debts, they have the option of going through a legal process called bankruptcy to receive relief from their creditors. In this article, we provide an overview of everything that you need to know to understand the basics of bankruptcy, including what it is, its advantages and disadvantages, and the most common types.
What Is Bankruptcy?
Bankruptcy is a legal proceeding freeing a person from paying their debts while providing an opportunity for their creditors to be repaid. Individuals and businesses can both file for bankruptcy. In the United States, the bankruptcy process is overseen by the bankruptcy court and governed by the Bankruptcy Code.
Advantages of Bankruptcy
The reason why people file for bankruptcy is usually to get a fresh start with their financial affairs when they are unable to pay back the debts they owe. Indeed, the bankruptcy process is intended to free people from unmanageable debts. As such, it offers the following benefits.
- Bankruptcy triggers an automatic stay that stops debt collectors from continuing their efforts. This can be a major relief if you have been struggling with being hounded by aggressive debt collectors calling you at all hours of the day and night.
- Bankruptcy discharges all eligible debts, leaving the debtor with far fewer or even no more debts to pay. This effectively represents a fresh start for people who have found themselves buried under a mountain of debt they cannot climb out of.
- By triggering an automatic stay and discharging eligible debts, bankruptcy can prevent repossession, foreclosure, wage garnishment, and utility shutoffs - all major stressors that can come along with being insolvent
Disadvantages of Bankruptcy
Of course, bankruptcy isn’t as simple as having one’s slate magically wiped clean with no consequences. The process has its disadvantages, too, including the following.
- In Chapter 7 bankruptcy, the fastest and usually most sought-after type, the debtor’s non-exempt assets are seized and sold off in order to pay off some of their debt. This can mean losing a major portion of what you own.
- Bankruptcy has long-term negative effects on your credit score, staying on your credit report and in the public record for between seven to ten years. This can make it difficult to get loans and lines of credit in the future and usually comes with higher interest rates.
- Bankruptcy makes debtor’s insurance premiums go up
- If you need to file for bankruptcy again in the future, you will need to wait between two and eight years to do so
- Bankruptcy is a public process and your financial status will not be private
Types of Bankruptcy
There are several types of bankruptcy that differ significantly in terms of who they are for and how they work. The most common types of bankruptcy are as follows.
- Chapter 7 bankruptcy - All of the debtor's non-exempt assets are seized and sold in order to pay off their creditors in order of priority according to the Bankruptcy Code
- Chapter 11 bankruptcy - Businesses must submit reorganization plans that allow them to restructure their debts and continue to operate with the goal of becoming profitable again
- Chapter 13 bankruptcy - Used by debtors with an average income or higher to develop a plan to pay back parts or all of their debts
How the Bankruptcy Process Works
While it can vary depending on the individual case at hand, the bankruptcy process generally looks something like this:
- A debtor must begin the bankruptcy process by taking mandatory credit counseling sessions
- Next, a debtor officially initiates the bankruptcy proceeding by filing a petition full of forms detailing relevant financial information such as their assets and debts
- After a bankruptcy case is on file, it is given a case number and assigned a bankruptcy trustee to oversee and administer the proceedings
- Once a debtor has filed for bankruptcy, an automatic stay is issued stopping creditors from their collection efforts
- Early on in bankruptcy, the debtor must attend a 341 meeting of creditors with the bankruptcy trustee to go over and verify information from their petition. Creditors may attend but rarely do.
- The next step in the bankruptcy process depends on the type of bankruptcy. In Chapter 7, the debtor’s assets are seized and sold off to pay back part of their debts. In Chapter 11, the business submits a reorganization plan for the bankruptcy court’s approval. In Chapter 13, the debtors begin a repayment plan to pay off some of their debts.
- Next, the debtor must complete a debtor education course
- Once the debtor has completed the course, their eligible debts are discharged. This removes their obligation to pay their creditors.
- With the bankruptcy process officially over, the debtor must begin to rebuild their credit and manage their finances such that they hopefully do not need to file for bankruptcy again
Debts Eligible for Discharge in Bankruptcy
While not all debts are eligible for discharge under bankruptcy, many are. The debts that can be discharged in Chapter 7 bankruptcy include:
- Old tax penalties and unpaid taxes
- Personal loans from friends and family
- Most auto accident claims
- Repossession deficiency balances
- Collection agency accounts
- Overdue rent
- Most civil court judgments
- Medical bills
- Most attorneys' fees
- Business debts
- Overdue utility balances
- Credit card charges, including overdue and late fees
In Chapter 13 bankruptcy, some more debts are eligible for discharge including:
- Willful and malicious property damage
- Debts incurred to pay nondischargeable taxes
- Some debts arising out of divorce or separation property settlement
In contrast, debts that are not eligible for discharge in any type of bankruptcy include:
- Child support
- Tax liens
- Debts for death or personal injury caused by a debtor’s DUI
- Debts that the debtor failed to list in their bankruptcy filing