How Bankruptcy Works

Personal Bankruptcy

Alternatives to Bankruptcy

Filing for personal bankruptcy is a serious decision, one that should be made after careful consideration and, if possible, with the advice of a lawyer. Entering into bankruptcy can help to alleviate your debts, but it will also affect your credit rating and your ability to borrow money in the future. So while it can be a good option for those who need it, personal bankruptcy should be a last resort after other alternatives have been exhausted. With that in mind, let's first consider a few alternatives to filing for bankruptcy.

The most basic alternative to filing for bankruptcy is to simply do nothing. If you owe money to creditors but have a small (or no) income, you may be considered judgment proof -- also called collection proof. Being judgment proof means that creditors would have nothing to take from you if they decided to sue you in court. Also, in some cases, creditors may decide to simply write off your debt rather than pursue repayment, and in seven years, that debt would be erased from your record. Still, keep in mind that if your financial condition does improve, you may no longer be considered judgment proof and creditors may approach you once again for repayment of debts.

A second possibility is to negotiate with creditors and to work out an individual payment plan. However, this process can be daunting, especially when dealing with creditors who are particularly aggressive or intimidating.

Instead of personally negotiating with creditors, you can contact a debt management agency for help. These agencies are nonprofit entities, and a listing of them can be found on the United States Trustee's Web site. Working with an agency means that no bankruptcy will appear on your record. But there is a drawback to working with a debt management agency: you won't have the protections provided by Chapter 7 or 13. Namely, agencies often require debts to be paid in full, and they can cancel your plan if you fall behind on payments. Another common concern related to debt management agencies is that they are heavily funded by creditors, a situation which may produce a conflict of interest for the agency.

Individual Filing

You're now aware of some of the alternatives to filing for bankruptcy. But you might still be thinking about filing, so let's consider the various possibilities for personal bankruptcy. We'll also look at the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 and how this "new" law affects individuals filing for bankruptcy.

Individuals are eligible to file for bankruptcy under Chapter 7, 11, 12 or 13. As discussed earlier, Chapter 11 usually applies to businesses, but it can apply to individuals with extremely large debts, such as someone whose debt exceeds the limits for filing under Chapter 13 (according to Findlaw.com, secured debts must be less than $922,975 and unsecured debts less than $307,675).

A Chapter 7 filing means that the debtor has no hopes of paying off his or her debts and is looking for a fresh start. Now, as a result of the Bankruptcy Abuse Prevention and Consumer Prevention Act of 2005, the debtor must take a Means Test in order to qualify for protection under Chapter 7. If your current monthly income (which is actually your average monthly income for the six months prior to filing) is greater than the median income for a family of the same size in your state, you generally can't file for Chapter 7. Here's an example of how the Means Test works. In 2005, the estimated average yearly income for a four-person family in Georgia was $64,427. That translates to an estimated average monthly income of $5,368.92. So, if your average monthly income for the six months prior to filing for bankruptcy was greater than $5,368.92, you aren't eligible to file for Chapter 7 and will probably have to file under Chapter 13 [ref].

After filing, the debtor is assigned a court-appointed trustee. The trustee will organize the sale of the debtor's assets. The debtor may be allowed to retain certain items, such as a house or part of the value of a car, based on exemption laws, which can differ drastically from state to state. Any non-exempt assets are sold by the trustee and used to pay off a portion of the filer's debts. Because the debtor cannot afford to pay off all of his or her creditors, some debts may be discharged and will not have to be repaid.

Both Chapter 12 and 13 are designed to help an individual with a regular income to restructure his or her debts. The main difference is that Chapter 12 is designed for farmers. These types of filing can be more favorable for the debtor than Chapter 7 because it allows the filer to retain most (or even all) of his or her assets and to form a plan to repay debts over a period of several years. Unlike someone who files for Chapter 7, a Chapter 13 debtor is not immediately discharged from his or her debts. Like Chapter 7 filers, the debtor is assigned a trustee, with whom the debtor must form a repayment plan. The court either approves the plan or orders changes. Once the plan goes into effect, the debtor has three to five years to repay his or her debts, and frequently the debtor only has to repay 30 to 50 cents on the dollar.

Moral Obligation

If a business or individual goes through bankruptcy successfully, many of their debts are legally discharged. Creditors no longer have any legal right to collect on those debts. However, the moral obligation to pay those debts remains. This might seem inconsequential -- if the law says the debt is forgiven, why would anyone pay it? There are certainly situations in individual bankruptcies where the moral obligation is important. If your parents loaned you money, you would probably feel a responsibility to pay them back, even if your parents "discharged" the debt. It can be even more important for business owners. If a business goes through Chapter 11, it would probably want to make some good faith payments toward debts if they ever wanted to use the same suppliers once the reorganization is complete.