10 Common Bankruptcy Questions

In the United States, bankruptcy is a legal process for settling debts between a debtor and his or her creditors. Current bankruptcy law, based on the Bankruptcy Code of 1978, is designed to relieve honest debtors of their burden -- by either erasing debts or negotiating partial repayment -- and offer the chance for a fresh start.

Bankruptcy was not always such a "liberating" experience. As early as Roman times, bankruptcies were forced on merchants who couldn't pay their debts, and their assets were seized and sold to pay off creditors. As recently as the mid-1800s, insolvent Americans could be thrown in debtors' prisons if they couldn't pay off their creditors [source: Encyclopaedia Britannica].

Today, bankruptcies are voluntary. A person chooses to file bankruptcy when there is no hope of paying medical bills, credit card balances and other insurmountable debt. Bankruptcy offers certain legal protections for debtors [source: Nolo]:

During bankruptcy proceedings, a bankruptcy court determines the best method for satisfying creditors without stripping the debtor of basic necessities. In the end, any remaining unpaid debt is discharged. While bankruptcies offer a fresh start, they leave a deep scar on your credit report that can make it difficult to qualify for credit in the future.

Bankruptcy should only be used in the direst of financial circumstances. It is too damaging to your credit to waste on temporary financial difficulties. But how do you know if your debt problem requires a solution that serious?

Here are some signs that you might be a good candidate for bankruptcy [source: Atlas]:

If you answered "yes" to several of the above questions, your first step should be to meet with a credit counselor. Avoid "credit consolidation" services advertised on TV or online. Unfortunately, some of these services are scams. Instead, use the list of approved credit counselors provided by the U.S. Department of Justice.

A credit counselor will be able to assess the seriousness of your situation and decide if bankruptcy is the only solution to free you from your debts. In many cases, though, there are viable alternatives. Learn more on the next page.

The bankruptcy process offers some tremendous benefits, but also some serious downsides. Not only does it stain your credit history, but the process is complicated and expensive -- expect to pay hundreds of dollars in filing fees, and that's without a lawyer!

As painful as bankruptcy is to the debtor, it's even more so for the creditor. In a typical bankruptcy, creditors receive little, if any, of the money owed to them. As a result, creditors are generally willing to negotiate the terms of debt rather than forfeit the whole thing in bankruptcy. Mortgage lenders are in the same boat; it's a much better deal for them to refinance your home at a lower interest rate than to foreclose.

So, with the help of a credit counselor, contact your creditors and mortgage lender and see if they are willing to lower minimum monthly payments or interest rates on your balances.

If your creditors won't negotiate, consider other ways to avoid bankruptcy. Attempt to sell property and other valuable possessions that could be used to pay down your debt. Get a second job and attempt to live on a strict budget.

In many cases, though, no amount of belt-tightening and yard sales will make a dent in the tower of debt incurred by medical bills, a failed business or a costly divorce. If there is truly no other option, then it's time to figure out what type of bankruptcy is right for you.

Officially, there are six different types of bankruptcy, each named after its respective chapter of federal bankruptcy law. But for the vast majority of people, there are only two real choices: Chapter 7 or Chapter 13.

Chapter 7 is called a "straight" bankruptcy, because it's relatively simple and quick. All of the debtor's assets are sold -- except for those that are exempt, which we'll talk about later -- and the proceeds are distributed among the creditors. The title of Chapter 7 in the bankruptcy code is Liquidation. The irony is that most Chapter 7 filers have no real assets to liquidate, at least none that aren't protected by exemptions.

To qualify for Chapter 7, you have to earn less than your state's median income, preferably a lot less [source: FindLaw]. If your income is too high, then your creditors might argue that you can, in fact, afford to pay back the debt in installments, which brings us to Chapter 13.

Chapter 13 bankruptcies are for people who earn a steady paycheck, but still can't afford to pay all their debts on time. Chapter 13 allows the debtor to consolidate his or her debts, negotiate a lower total balance, and submit a three- to five-year plan for paying back the debt in monthly installments. If a Chapter 13 filer fails to make timely payments, the case can be converted into a Chapter 7 liquidation.

To declare bankruptcy, you need to file a petition with a federal bankruptcy court. Use this search form to find the bankruptcy court nearest you. Even though the bankruptcy process is overseen by a court, debtors are not on trial. It is not a crime to be in debt. It's not even a crime to default on your debts. The role of the court is to assess the facts of the debtor's financial situation and ensure that creditors receive fair compensation.

Do you need a lawyer to file for bankruptcy? Technically, no. It is possible to file all of the necessary paperwork and attend the required meetings without an attorney, but the bankruptcy court itself strongly advises hiring a bankruptcy attorney [source: U.S. Courts]. An attorney will ensure that all outstanding debts are listed and properly discharged, that you don't miss any important filing deadlines, and that you don't do anything that could constitute bankruptcy fraud.

In most bankruptcy cases, you will never see a judge. Your main contact at court is the trustee. The trustee will review all of your financial statements and preside over a meeting of creditors held at the bankruptcy court (more on that next). In a Chapter 7 case, the trustee identifies all nonexempt assets and sells them to raise money to pay back creditors. In a Chapter 13 case, the trustee collects all financial records and ensures that the repayment plan is fair to creditors. The trustee also receives the monthly payments once the plan is approved [source: Bulkat].

Do your creditors have any say during bankruptcy proceedings? Keep reading to find out.

As we mentioned earlier, bankruptcy is bad news for creditors. In both Chapter 7 and Chapter 13 bankruptcies, the creditor is almost guaranteed to receive much less than the total debt; sometimes they don't even get one red cent. It's in the creditor's interest, therefore, to look for holes in a debtor's bankruptcy case.

After filing a petition for Chapter 7 or Chapter 13 bankruptcy, the debtor is required to attend a meeting of creditors overseen by the court-appointed trustee. All creditors are invited to the meeting to ask the debtor questions about his or her finances. If a creditor believes that the debtor lied on credit applications or is attempting to hide assets from the court, he can file an objection called an adversary proceeding within 60 days of the meeting of creditors [source: Michon].

An adversary proceeding is rare, but it's essentially a separate lawsuit filed with the bankruptcy court on behalf of one of your creditors (or even the trustee). Adversary proceedings, unlike regular bankruptcy cases, are handled by a judge. If the judge finds that the debtor intentionally committed fraud to avoid paying back a debt, the debtor could be tried in a separate criminal case. Bankruptcy fraud is a federal offense that can carry serious jail time.

Bankruptcy is designed to free struggling people from crushing levels of debt, but it's not a cure-all. There are several kinds of debts that even bankruptcy can't erase [sources: U.S. Courts, Michon, New York Fed]:

The bankruptcy court is also limited by what the debtor reports on his or her financial statements. If a creditor is not listed on bankruptcy documents, the debt will not be discharged. This is yet another reason to hire a bankruptcy attorney.

No, even though it's not good news. If your credit score was low before the bankruptcy -- the result of late payments and collections -- it won't get much worse afterward. If your score was high, though, expect a steep drop after declaring bankruptcy.

A completed Chapter 13 bankruptcy stays on your report for seven years and a Chapter 7 bankruptcy stays on for 10 years [source: FICO]. This is similar to late payments, collections, foreclosures or other matters of public record (tax liens, civil lawsuits) that also mar your record for seven years.

Each lender has its own rules for allowing you to reapply for credit. For FHA-backed mortgages, the waiting period is two years after a Chapter 7 discharge before you will be considered. And even then, you must show documented proof that you can successfully manage your finances. Chapter 13 filers can apply after a year of on-time installment payments [source: HUD].

Fannie Mae, however, has stricter post-bankruptcy mortgage lending rules: a minimum of four years after a Chapter 7 and two years after a Chapter 13.

Credit cards, ironically, will clamor for your business, but beware! Since federal law prevents you from declaring Chapter 7 within eight years of a previous Chapter 7 filing, the credit card company knows that you'll be on the hook for any balances you run up on the new cards, which also carry extra high interest rates [source: Michon].

Both federal and state bankruptcy laws allow for specific exemptions -- property that cannot be sold by a Chapter 7 bankruptcy trustee to pay off creditors. (You're much less likely to lose property in a Chapter 13 case, because you agree to pay creditors over time.)

Your house is only worth liquidating in Chapter 7 if the trustee will actually make money selling it back to the bank. The federal homestead exemption is $22,975. If your home equity is equal or less than that figure, you'll probably keep your house. If not, the trustee will sell your house and give you $22,975 [source: Bulkat].

How about your car? Again, federal law exempts up to $3,675 of equity in a vehicle. If you own a car outright and it's worth more than $3,675, you might lose it in a Chapter 7 bankruptcy.

In terms of household goods, federal exemptions protect up to $12,250 of furniture, appliances and clothing. You can keep exactly one TV, one VCR (does anyone even have those anymore?) and one computer. Jewelry is protected up to $1,550, but wedding rings are fully exempt [source: Cornell University Legal Information Institute].

As for income, the trustee can't touch alimony payments, life insurance payments, Social Security benefits or other government assistance.

One important note is that each state sets its own exemption rules. Some are more generous than the federal rules, and some are more restrictive. In a few states, you can choose between using the state or federal exemptions, but most states require you to use their exemption rules.

Sadly, it's not uncommon for people to declare bankruptcy multiple times. Like everything else associated with declaring bankruptcy, there are rules governing the waiting period between multiple filings, and they're just as confusing as everything else [source: Illinois Legal Aid]:

If you still have questions about bankruptcy or want to learn more managing debt, check out the related HowStuffWorks articles on the next page.