Each day in America, around 2,500 individuals and businesses file for bankruptcy [source: ACA International]. The ranks of the financially belly-up include former professional athletes, glitzy Atlantic City casinos and lots of regular folks who are simply drowning in debt. By the second quarter of 2014, American households carried $669 billion in high-interest credit card debt and $8.09 trillion in mortgage debt [source: New York Fed].
Nobody wants to go bankrupt. Nobody plans to be up to their ears in debt. But when the forces of evil converge — high unemployment, stagnant housing markets, aggressive debt collectors — bankruptcy is often the only defense against complete financial ruin.
Even if you are in a good place financially, it's important for everyone to understand exactly what bankruptcy means and how it can be both a curse and a lifeline. Is bankruptcy the same thing as going broke? What's the deal with all of the different "chapters" of bankruptcy? And what, if any, are the alternatives for folks in serious financial straits?
Keep reading for our 10 facts about bankruptcy that absolutely everyone should know.
Bankruptcy Is a Legal Process for Settling Debts
Let's start with some important definitions and distinctions. Declaring bankruptcy doesn't necessarily mean that you're broke. You could have millions of dollars in the bank and a well-paying job and still go bankrupt. Bankruptcy isn't a financial state, like "rich" or "poor." It means that you owe more money (debt) than you can possibly repay. Bankruptcy, by definition, is a legal process for settling debts [source: California Courts].
To explain, let's use a hypothetical example. Steve has been laid off from his job for a year. His wife's salary isn't enough to cover all of their expenses — mortgage, food, utilities, medical bills — so they've been putting everything on their credit cards. When they're no longer able to make minimum monthly payments on the cards, the collection notices started arriving. Then the phone calls from collection agents, sometimes three or four a day.
Steve and his wife owe $70,000 in credit card debt, but only have $2,000 in the bank. The only thing of real value that they own is their home, but should Steve and his family go homeless because they're in debt?
In the U.S. Constitution, Article 1, Section 8 authorizes Congress to enact "uniform Laws on the subject of Bankruptcies" [source: U.S. Courts]. It was in the Founders' best interest — and continues to be in our national interest — to offer legal relief to people unable to pay back their debts. In place of "debtor's prison" or "indentured servitude," bankruptcy offers a formal way for debtors and creditors to strike a deal.
Bankruptcy Is a Fresh Start, Not a Life Sentence
Bankruptcy has such a strong negative connotation that many people think it's an actual crime. This confusion is exacerbated by the existence of U.S. bankruptcy courts, whose job is not to "prosecute" offending debtors, but to make sure that both debtors and creditors receive their due process under federal bankruptcy law.
In almost all cases, an individual or company files for bankruptcy voluntarily. It's not a court-mandated sentence for some other crime. Nobody is excited about declaring bankruptcy, but it's not a scarlet letter or a death sentence. In fact, it's a lifeline.
The goal of bankruptcy is to determine how much a debtor can reasonably pay to each creditor and to discharge or erase the remaining debt. Sure, the creditors won't get every cent they are owed, but it's better than nothing. The debtor doesn't get off scot-free, but he's not forced to dig his way out of a bottomless pit, either. In short, bankruptcy is a compromise.
Once you've settled your debts through bankruptcy proceedings, your creditors aren't allowed to hound you anymore. A bankruptcy will remain on your credit report for seven to 10 years, but after that, you'll have a clean slate [source: Michon].
You'll See a Trustee, Not a Judge
In the United States, bankruptcy filings are handled by federal bankruptcy courts. There are 90 such courts corresponding to 90 different bankruptcy districts across the country [source: U.S. Courts]. Although bankruptcy cases are overseen by a federal court, few debtors ever see the inside of a courtroom, and even fewer interact with an actual bankruptcy judge. Your main government contact throughout a bankruptcy case is someone called a trustee.
The trustee is appointed by the court to manage all aspects of the bankruptcy case and assure that all parties — debtors and creditors alike — get a fair shake. In reality, the trustee doesn't represent either the debtor or the creditor, but the bankruptcy estate [source: Dzikowski]. In a Chapter 7 case, for example, all of your nonexempt assets become part of the estate. It's the trustee's job to assess the value of the assets, sell them and distribute the cash to creditors.
Federal bankruptcy trustees aren't lawyers. They're a combination of administrative officers and investigators. Technically, trustees are part of the U.S. Department of Justice. One of their roles is to make sure that debtors and creditors aren't trying to defraud the system.
Next we'll unravel the mystery about different kinds of bankruptcies.
Chapter 7 Bankruptcy Is Liquidation
There are a total of six different types of bankruptcy in the United States: Chapter 7, Chapter 9, Chapter 11, Chapter 12, Chapter 13 and Chapter 15. Chapters 9, 12 and 15 filings are very rare, restricted respectively to municipalities, farmers and Americans who owe debts both in the U.S. and abroad. The other three — 7, 11, and 13 — get most of the action.
Chapter 7 bankruptcy is all about liquidation. In a Chapter 7 case, the bankruptcy trustee calculates the total value of the individual or business's assets and liquidates just about everything — sells it, in other words — for cash. That cash is then used to pay off creditors. Any remaining debts are discharged immediately. Case closed.
Most individuals and businesses who file for bankruptcy choose Chapter 7 bankruptcy. Roughly 670,000 of the 1 million bankruptcies filed by both groups together from June 2013 to June 2014 were Chapter 7 cases [source: U.S. Courts].
The bankruptcy trustee is not allowed to liquidate absolutely everything in a Chapter 7 case. Each state has its own laws about exempt and nonexempt assets. In most cases, people can keep their home or at least a significant portion of the equity in their home; retirement savings; insurance policies; personal property like furniture, clothing and jewelry; a car; and any public benefits like Social Security or unemployment benefits [source: Nolo].
Because of all of these exemptions, the majority of Chapter 7 cases involving people are "no asset" bankruptcies [source: U.S. Courts]. Essentially, there's nothing for the trustee to sell, so all debts are simply discharged.
Chapter 13 Bankruptcy Requires a Plan
Chapter 7 is the fastest way to discharge unpaid debt, but it's not for everybody. If you've invested a lot of equity in your house, for example, you could lose it through Chapter 7. If you have significant assets and a regular source of income, Chapter 13 bankruptcy is often the better choice.
In some cases, choice has nothing to do with it. If you make too much money, the bankruptcy courts simply won't allow you to declare Chapter 7. The calculation is done using something called the means test. Essentially, if the court determines that you have enough disposable income (the "means") to pay back a portion of your debts without resorting to liquidation, then that's what you have to do [source: Nolo].
Under Chapter 13 bankruptcy, the court-appointed trustee works with the debtor and creditors to come up with a repayment plan. The creditors won't get all of their money back, but the debtor is forced to live on a very tight budget for three to five years, allocating every spare penny to repayment.
Almost a third of all individual bankruptcy filings from June 2013 to June 2014 were Chapter 13 cases. In contrast, a mere 8 percent of businesses declared Chapter 13 bankruptcy [source: U.S. Courts].
Chapter 11 Bankruptcy Is Reorganization
Chapter 11 bankruptcy is almost exclusively declared by businesses. In a Chapter 11 case, the business is so overburdened by operating debt and sluggish revenue that it can't possibly pay off existing contracts, or the salaries of its workers, without going under. By filing for Chapter 11 bankruptcy, the business doesn't have to call it quits — instead, it can call a financial "time out."
By filing for Chapter 11 bankruptcy, a struggling business buys itself some time to take a step back from its financial collapse and rethink the way it does business. As part of the Chapter 11 bankruptcy proceedings — known as a "reorganization" — the business is given 120 days to come up with a plan to restore itself to profitability and pay back creditors.
Under the reorganization plan, the company might close some of its retail stores, restructure its corporate leadership or streamline its product or service offerings. Chapter 11 bankruptcies also allow business to void existing contracts — including labor contracts with unions — and renegotiate better terms. The idea is to cut costs across the board to pay back creditors and keep the company afloat.
Once the bankruptcy court approves the reorganization plan, the company proceeds with business as usual. Sort of ... Until it emerges from Chapter 11 protection, the company must get permission from the court to buy or sell major assets, lease new property, expand or shut down business operations, or modify contracts and agreements [source: Maidman].
Recent high-profile companies to enter Chapter 11 bankruptcy include General Motors, A&P grocery stores, Hostess Brands and Eastman Kodak [source: Cauchon]. Only 10 to 15 percent of Chapter 11 cases successfully emerge from bankruptcy protection [source: Maidman]. Most end up as Chapter 7 yard sales.
Debts Are Not Erased Immediately
A key component of all bankruptcies is the discharge — or forgiveness — of debt. Once the creditors receive their court-approved payments, all remaining debt is erased from the debtor's record.
How long does a debtor have to wait before his debts are discharged? That depends on the type of bankruptcy filed. The quickest turnaround is a Chapter 7 case. Once the bankruptcy trustee sells off all of the debtor's nonexempt assets, a distribution plan is presented to the creditors. The creditors then have 60 days to file an objection to the terms of the distribution [source: FindLaw]. Once that window expires, all remaining debt is discharged and the debtor is free and clear – about four months in total from the time the petition is filed.
In both Chapter 11 and Chapter 13 cases, the timeline for discharging debt is a lot longer. In those bankruptcies, the individual or business is required to adhere to a strict payment plan over the course of three to five years. Any remaining debts will not be discharged until that plan is completed to the satisfaction of the bankruptcy court.
In addition, individual filers of Chapter 7 and Chapter 13 bankruptcies are required to complete an instructional course in financial management or credit counseling [source: FindLaw]. Failure to take the course could stretch the discharge timeline even further or result in dismissal of the case.
Some Debts Can't Be Discharged
If you're prudent with your finances and work hard to avoid debt, it might sound unfair that bankruptcy courts will forgive someone's debts just because they couldn't repay them. Where's the accountability?
First off, not all debts can be erased. In fact, there are 19 separate categories of debt that are off-limits to bankruptcy protection. The most significant obligations that must be paid — no matter what — include [source: Harelik]:
- Alimony and child support – Any money owed to children and ex-spouses must be paid, regardless of bankruptcy, and that includes any legal fees owed to an ex-spouse from divorce proceedings.
- Student loans – Yup, even bankruptcy won't free you from student loan debt, and that includes federal, private and school-based loans.
- Taxes – If you owe money to the IRS, you're most likely stuck with it.
- Fines and restitution – If you committed an offense that resulted in court-ordered payments, you're still on the hook for that money.
- Personal injury – If you owe money from a personal injury case, that can't be discharged. That includes any debts related to a drunk driving case.
You're Better Off With a Lawyer
Filing for bankruptcy without a lawyer is about as smart as jumping out of an airplane without a parachute. Sure, there's a slim chance you'll make it, but you're guaranteed to get beat up in the process.
People filing for bankruptcy aren't required to hire a lawyer, but in most cases it's strongly recommended. Bankruptcies are extremely complicated legal processes with loads of paperwork, deadlines and bureaucratic hoops to jump through. Forget one deadline or file incomplete paperwork and your case will be tossed out. Mess up badly enough and you may forfeit the right to file a second time [source: U.S. Courts].
The only type of bankruptcy that you should even consider filing on your own is a Chapter 7 case. If you have no home, no car and earn below the state median income, your case will be fairly straightforward [source: Bulkat]. But it will still require filing the right forms and showing up for the right hearings. If you can't afford a bankruptcy lawyer, many law schools and community organizations offer free legal services, including free bankruptcy preparation.
One of the best reasons to hire a bankruptcy lawyer is to avoid taking any actions that smell like bankruptcy fraud. If you try to hide or destroy assets that could be sold by the bankruptcy trustee, that's a federal crime and could land you in prison [source: U.S. Courts].
There are Alternatives to Bankruptcy
While bankruptcy is certainly not the end of the world, it should not be entered into lightly, either. A bankruptcy on your credit report will severely limit your ability to buy a home, a car or qualify for business loans. If you find yourself in dire financial straits, consider all of your options before filing for bankruptcy.
The first place to start is with a credit counselor. A warning, though — there are lots of unscrupulous businesses out there selling themselves as debt consolidation services promising to lower your payments. Unfortunately, some of those are scams. To find a reputable credit counselor in your area, visit the Department of Justice's Credit Counseling and Debtor Information page.
With help from your credit card counselor, you may be able to cut back on unnecessary expenses and increase your income enough to slowly pay down your debt over time. If necessary, the credit counselor can help you negotiate with your creditors to lower your interest rate or minimum payments. Creditors tend to be more flexible when the alternative is default. If you own a house, can you refinance for a lower interest rate? If not, it's better to sell the home than to risk foreclosure or bankruptcy.
Even if you feel like you're out of options, meet with a bankruptcy lawyer before filing with the court. The lawyer will consider your specific financial needs and determine if bankruptcy is indeed the best option.
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Author's Note: 10 Pieces of Bankruptcy Information Everyone Should Know
Bankruptcy is one of those things that I hoped to remain ignorant about, like how to survive a plane crash or the best treatments for body lice. These are things you don't generally look into unless you have to. I am no financial wizard, but I am lucky to be married to a woman who knows enough about personal finance to populate a spreadsheet and maintain a frugal budget that usually keeps us in the black. I can't imagine the stress of being in serious debt and facing the prospect of bankruptcy. Researching the writing this article has opened my eyes to the complexity and calamity of bankruptcy and given me 10 more good reasons to thank my wife.
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