What Actually Happens When You File For Bankruptcy

What happens when you can't pay your debts? Once upon a time, you might have ended up in debt bondage in ancient Greece. Being a debtor means that you, and sometimes your family, work for someone you owe money to pay off your debt. This is different from slavery in that once you pay off your debt, you are freed. Later in history, as in Victorian England, the poor were thrown into horrible debtor's prisons, only to be released when friends or family paid their debts in full. Other debtors' prisons function much like workhouses, with debtors paying off their debts and board and lodging to be free. Many countries are currently implementing a form of bankruptcy that manages debt and allows debtors to start over financially. This is not to say that questionable debt practices no longer exist; debt bondage is still in place in some parts of the world, such as South Asia and sub-Saharan Africa. The United Nations estimates that 8 million people are trapped in bonded labor. Thankfully, many groups are working to improve the lives of and free people from what the UN considers a 'modern-day slavery practice.'

The basics of how personal bankruptcy in the US works.

Today, however, we will cover the basics of how personal bankruptcy in the US works. There are six different types of a possible bankruptcy in the United States. They are all named after parts of the Bankruptcy Code. They can be found in Chapters 7, 9, 11, 12, 13, and 15. Each chapter covers a different type of bankruptcy. For example, Chapter 9 applies to bankruptcy in a municipality such as a city. The majority of individuals file one of two types of bankruptcy, Chapter 7 or Chapter 13. People choose to declare bankruptcy for a myriad of reasons. Many financial literacy websites such as Investopedia state that a significant amount of people declare bankruptcy each year in the US due to costly health events. Two other primary reasons people file for bankruptcy are losing employment and poor financial choices, including excessive spending. Bankruptcy is a legal proceeding where an individual, spouse, or business makes a formal request to a federal court, declaring that they cannot repay outstanding debts. Each type of bankruptcy requires different forms and procedures. For Chapter 7 bankruptcy, the debtor petitions the court that they cannot pay their debts. So let's walk through how a Chapter 7 bankruptcy could proceed: Meet James. He has some student loans from getting his college degree, some credit card debt, medical debt from an emergency ER visit, and until five months ago, a decent job. 

Government-mandated credit counseling.

Unfortunately, James quickly ran through the small savings after being laid off. While James has moved into his parent's basement to save money and has been working some temporary gigs while he continues to look for a permanent job in his industry, he's months behind some bills. James decides to file bankruptcy. The first step is that James must undergo government-mandated credit counseling. The US Trustee's Office maintains an approved list of agencies that provide counseling at a reasonable cost. Debtors are required to file a certificate of counseling completion along with their other bankruptcy forms. Sometimes, pre-bankruptcy credit counseling helps debtors develop a plan to resolve their debts without bankruptcy. James' second step is to file bankruptcy forms with the court and pay fees associated with the cost of his case. In some instances, debtors can request a fee waiver. Generally, mandatory bankruptcy court fees cost between $300-$400. The bankruptcy paperwork James has to fill out is pretty extensive; it includes forms listing financial information, assets, income, expenses, and property exemptions. An essential requirement for a Chapter 7 bankruptcy is that the debtor does not have sufficient income to pay even a portion of their debts. If the debtor has enough income, they must file under Chapter 13 bankruptcy, which we'll discuss shortly. \

Chapter 7 or Chapter 13?

The type of personal bankruptcy to File Chapter 7 or Chapter 13 is determined through The Bankruptcy Means Test, which calculates the debtor's income, expenses, and debts to see if any repay is possible. Once James has completed the filing part of the bankruptcy process, an automatic stay goes into effect. This stay stops most debt collection efforts, which James appreciates. Constant calls from creditors have been making him anxious. In addition to halting communication from creditors, automatic stays stop wage garnishments.

Meeting of creditors.

In some cases, they even temporarily stop repossession, foreclosure, or eviction proceedings for the duration of the debtor's case, allowing time for the debtor to agree with the creditor. After James files paperwork, the court appoints a trustee to handle his bankruptcy case. The trustee reviews James's paperwork. Then his assets become part of the bankruptcy property and are scrutinized and evaluated by the trustee. The fourth step in the bankruptcy process is the meeting of creditors held by the court. At the meeting, James, under oath, answers questions about his finances from the trustee and any creditors who choose to show. Once the trustee gathers and reviews all applicable information about James' debt, the court decides whether James is eligible for Chapter 7 bankruptcy protection. 

Sell your assets or not.

If the court denies eligibility, James may have the option to file for Chapter 13 bankruptcy. Thankfully the court granted James' petition. The trustee now decides which of James' assets to sell off for money to pay his creditors. Some assets are considered exempt from liquidation, such as the house the debtor lives in as long as the mortgage is current, household furnishings, or a personal vehicle up to a specified value--essential assets needed to maintain life. Common assets that are not considered exempt are investments, jewelry, valuable artwork, or collectible items such as a stamp collection. Each bankruptcy case is unique, and the assets sold depend on the facts in the individual case. Also, different states set their own rules as to what assets are exempt and nonexempt. Seventeen states allow debtors a choice. They can either choose the state exemption system or follow another set of exemptions created by Congress, called the federal bankruptcy exemptions. 

Don't lie

If a debtor lies or tries to hide assets and is caught, they can face penalties and not discharge their debts. In some cases, debtors can face criminal charges for fraud for providing false information when filing for bankruptcy. Depending on the individual situation, the debtor may negotiate with the trustee to keep the nonexempt property if they have enough cash or are willing to give up an exempt property instead. So James has to sell his coin collection to pay his debts but can keep his paid off, years old commuter car. Depending on the state, a debtor may only receive an exemption for the functional version of an essential item. For example, if James owned outright a $40,000 car sports car, his trustee may sell the car for $40,000, use $35,000 to pay James's debts, and give him a $5,000 credit for an exempt vehicle. James must resolve any secured debt by either returning the collateral or property or reaffirming the debt, meaning that he will continue to make payments. If James didn't own his car outright and had an overdue car note, he would have to let the car be repossessed or get current on the car note and continue to make payments. James will have to let it go if it's an expensive sports car, but it may behoove James to figure out a plan to keep making payments if it's a budget commuter car. The final step James must take is to complete a debtor's education course and file a certificate with the court confirming completion. Then generally, within 3-6 months after James has filed, he will receive his bankruptcy discharge notification, and the automatic stay is lifted. Within a few weeks of receiving his discharge, James' case is officially closed, and his unsecured debts--his credit card and medical debt are cleared, he will continue to have to pay off his student loans. 

Chapter 7 Public Record

The public record of a Chapter 7 bankruptcy remains on James' credit report for ten years. For Chapter 7 bankruptcy, some debts are not eligible to be discharged. Non-dischargeable debt includes spouse and or child support, most student loans, and income tax debt. Common debts that are wiped out are credit card balances, personal loans, and medical bills. Suppose money is owed on a secured debt, which means that the debt has collateral, such as a mortgage or vehicle loan. In that case, the debtor has a choice if they are current on their payments: they can allow the creditor to repossess the property, thereby discharging the debt or keeping the property and continuing to make payments under the original contract. Debtors who don't have any valuable assets and only own exempt property have their debt discharged and didn't repay any part of their unsecured debt. The majority of Chapter 7 bankruptcies filed for are granted. 

Chapter 13 bankruptcy.

For Chapter 13 bankruptcy, the debtor petitions the court with a different request. Instead of selling off assets and discharging debt like Chapter 7, debtors seek to reorganize their debt and establish a 3-5 year plan for repayment. Chapter 13 payments are then made monthly to the court-appointed trustee, effectively consolidating debts into one single amount. The trustee then distributes the money to the debtor's creditors, and the debtor doesn't have any direct contact with creditors. The Chapter 13 bankruptcy process may allow debtors to stop foreclosure proceedings and catch up on delinquent mortgage payments over time. It also will enable debtors to negotiate and possibly set new terms for vehicle repayment and lengthen payment plans for past-due income taxes, child support, and spousal support. Meet Nicole. She has a car note, a mortgage on a small house, and a pretty good job. Unfortunately, Nicole had a medical emergency last year and missed a few months of work, wiping out her savings and forcing her to primarily live on her credit cards. Even worse, the medical costs exceeded Nicole's medical insurance. Thankfully, Nicole has recovered and is back to work full-time. However, at this point, she's behind on her mortgage, car note, some of her credit cards, and has a lot of medical debt. When considering filing for Chapter 13, Nicole hires a bankruptcy lawyer. For Chapter 7 and Chapter 13, many debtors employ a bankruptcy lawyer to assist them through the process, which is confusing. Hiring a lawyer is more common with Chapter 13 because it tends to be more complicated. 

Bankruptcy lawyer

A bankruptcy lawyer can cost anywhere from $200 for a basic meeting up to around $6,000 if the lawyer appears in court for you or your case is complex. In Nicole's case, she feels like it's worth it to shell out a few thousand dollars to try to prevent the foreclosure of her house. Like Chapter 7, the first step in the Chapter 13 bankruptcy procedure is that Nicole must undergo government-mandated credit counseling. Then she files bankruptcy forms with the court and pays the fee associated with her case's cost. However, as a part of her filing, Nicole submits a debt repayment plan often developed during credit counseling. Also, it's likely Nicole's lawyer would help her create a debt repayment plan. Once Nicole has completed this part of the process, an automatic stay goes into effect, limiting communication from creditors and temporarily halting the foreclosure of her house.

The court-appointed trustee.

The court appoints a trustee to Nicole's case. Next, the court holds a meeting of creditors, and then within 45 days, a Chapter 13 confirmation hearing is also held by the court. For both court appearances, Nicole's lawyer goes with her. Nicole's lawyer has also been negotiating with her creditors to get her the best outcome possible. At the Chapter 13 confirmation hearing, Nicole's repayment plan is reviewed. Creditors may ask for clarification and raise concerns or objections to the repayment plan. By the end of this hearing, the debtor's plan is confirmed. The confirmation hearing is continued for another day, allowing time to redo the payment plan or negotiation between a debtor and creditor.

Confirmation hearing.

The bankruptcy case is dismissed or converted to a Chapter 7 bankruptcy at the confirmation hearing. Luckily, Nicole's repayment plan was accepted at her first confirmation hearing. Then the court considered whether or not to have Nicole's Chapter 13 monthly payment be deducted directly from her paycheck. They opted to let her make the monthly payment to the trustee on her own. Nicole will continue to pay monthly on her debts for the next five years. After five years, if Nicole has a remaining credit card and medical debt, it's discharged. She will continue to make mortgage payments for her house. Nicole could complete her car loan during the five years and now own her car outright. 

Chapter 13 repayment plan.

In general, Chapter 13 debtors must petition with repayment plans that can take 3-5 years to pay off. Once the years of repayment are completed, the record of the Chapter 13 bankruptcy stays on the debtor's credit report for seven years. During the 3-5 year repayment process, the debtor isn't allowed to incur any more debt, such as a new vehicle loan, without court approval. Also, debtors must maintain insurance on any collateral or properties. So why do people file for bankruptcy instead of seeking other options, mainly since declaring bankruptcy affects credit scores? A bankruptcy record makes it hard for a consumer to open new accounts, obtain unsecured loans or credit cards, and sometimes makes them ineligible to purchase a vehicle for several years. 

Bankruptcies can even affect getting security clearances or professional licenses. However, we'd like to stress that each bankruptcy is unique, and there's no one size fits all answer; it depends on the life situations the debtor is going through. Dealing with creditors can be extremely stressful, and others need a guided plan to begin rebuilding their financial health. Sometimes bankruptcy is simply the best option available.

Thank you for reading, and I hope you enjoyed that one. See you at the next one.