America is experiencing a personal debt crisis. Household debt in the United States totaled $11.63 trillion in the second quarter of 2014. The majority of that debt is held in mortgages ($8.09 trillion), but Americans also owe a crippling $669 billion in high-interest credit card debt and $1.12 trillion in student loans [source: New York Fed].
When you get more phone calls from debt collectors than friends and family, and every piece of mail is stamped with the words "Third and Final Notice," it might be time to consider declaring bankruptcy.
No one is excited to declare bankruptcy. It's not part of anyone's long-term plan. But, declaring bankruptcy can be the "best worst" option for people in severe financial distress.
To get started on this legal process for settling your debts, you must file paperwork with a United States Bankruptcy Court and meet the court's filing deadlines and other requirements dictated by both federal and state bankruptcy law. There are bankruptcy courts all across the U.S. assigned to 90 different federal districts.
Although bankruptcies are handled by courts, the individual declaring bankruptcy is not "on trial." Being in debt is not a crime. Filing for bankruptcy is more like applying for government assistance. The court's job is to determine the best way to settle your debts:
- If you don't have regular income, the court will liquidate some of your assets to pay back your creditors.
- If you make a steady paycheck, the court will work with your creditors to establish a three- to five-year payment plan.
- Any remaining debt that the court determines you cannot pay is discharged, meaning it's erased for good.
Living with runaway debt is incredibly stressful and can inflict a serious emotional and psychological toll on individuals, spouses and families. Declaring bankruptcy offers a way out, but it comes with a cost. Once you have filed for bankruptcy, it will stay on your credit report for seven to 10 years, seriously impairing your ability to qualify for new loans to buy a home, a car or start a business.
The first step to declaring bankruptcy is to make sure that bankruptcy is the right solution for your financial situation. On the next page, we'll go over your options.
Is Bankruptcy Right for You?
If you are tormented by creditors and see no way of paying off your debt, bankruptcy may very well be your only lifeline. But in many cases, there are alternative ways to resolve your financial troubles without resorting to bankruptcy proceedings.
One of the purposes of declaring bankruptcy is to negotiate a payment plan with creditors. But you don't have to declare bankruptcy to start negotiating. Contact your creditors and see if they will allow you to make smaller minimum monthly payments. If you can't afford your mortgage payments, see if the lender will refinance at a lower interest rate.
If you need help negotiating with creditors, consider meeting with a nonprofit credit counseling agency. The Department of Justice maintains a list of reputable credit counselors on its Credit Counseling and Debtor Information page. A credit counselor has experience working with creditors and might be able to strike a deal.
There is something important to understand about negotiating with creditors, though. One of the advantages of declaring bankruptcy is that a portion of your debt — or all of it — will be discharged, meaning you won't have to pay it back. If you negotiate with creditors outside of bankruptcy, any deal you make will likely involve paying back the full amount [source: Nolo].
If your creditors refuse to negotiate, your final option is selling off any and all assets to repay the debt: house, car, boat, jewelry, furniture -- anything that will generate cash to lower the debt. Again, a benefit of declaring bankruptcy is that in most cases your home and personal possessions can't be seized by the court to repay your creditors.
Even if you ultimately decide that bankruptcy is your best option, you will be required to participate in credit counseling before you can file your paperwork [source: U.S. Courts]. The counselor will make sure you understand your options and help determine if bankruptcy is the only way out. Telephone and online counseling are available in most states.
Next we'll look at the differences between declaring the two most common types of individual bankruptcy: Chapter 7 and Chapter 13.
Declaring Chapter 7 or Chapter 13 Bankruptcy
The two most common types of bankruptcies for individuals are Chapter 7 and Chapter 13, named for their corresponding chapters in the U.S. Code. The choice between Chapter 7 and Chapter 13 bankruptcy is largely determined by your finances:
- Chapter 7: Liquidation – For low-income debtors. The court sells any nonexempt assets and uses the money to pay creditors. The rest of the debt is immediately discharged.
- Chapter 13: Adjustment of Debts –For debtors with steady income. The filer agrees to a plan to repay a significant portion of the debt over three to five years. The rest is discharged.
The first step in declaring both Chapter 7 and Chapter 13 bankruptcy is the means test, a set of forms called schedules that determines whether you have the financial "means" to pay off your debts. To complete those forms, you will need the following information [source: U.S. Courts]:
- List of all creditors and the amounts owed to each
- Source, amount and frequency of your income
- List of all of your property
- Detailed list of your monthly living expenses
If the court determines that you don't make enough money to pay off even a portion of your debts, it will proceed with Chapter 7 bankruptcy. The court will assign an impartial trustee to sell all of your nonexempt assets and property, known as the bankruptcy estate. Since most property is exempt from sale under state and federal bankruptcy law, most Chapter 7 filers keep their homes, cars and personal belongings.
As part of the Chapter 7 process, most filers only appear in court once to meet with their trustee and creditors. One advantage of Chapter 7 is that all debt remaining after the liquidation of assets is discharged immediately.
In a Chapter 13 case, the debtor keeps all assets, but has to submit a repayment plant to the court. If the plan is approved, all debts are consolidated into one monthly payment, which can be automatically deducted from the debtor's paycheck. If the debtor earns less than the state median income, the repayment plan lasts three years. If the debtor earns more, it's five years [source: U.S. Courts]. Any remaining debt is discharged after successful completion of the repayment plan.
Next we'll look at some of the laws that govern the bankruptcy process and why you should definitely hire a lawyer.
Bankruptcy Laws and Exemptions
While it is technically possible to successfully file for bankruptcy without an attorney, it is not recommended. Declaring bankruptcy is a highly bureaucratic process full of arcane rules and baffling forms. For instance, in a Chapter 7 case, in addition to the bankruptcy petition, the debtor must also file with the court [source: U.S. Courts]:
- schedules of assets and liabilities
- a schedule of current income and expenditures
- a statement of financial affairs
- a schedule of executory contracts and unexpired leases
- a certificate of credit counseling and a copy of any debt repayment plan agreed to through counseling
- copies of tax returns, plus other documents
If you miss a deadline or file the wrong form, your case could be dismissed. If you mess up badly enough, you could be tried for bankruptcy fraud. If you can't afford a bankruptcy lawyer, get help from a free legal clinic at a law school or nonprofit legal advocacy organization.
The bankruptcy process in America is governed by both federal and state law. Almost all of the rules, forms and deadlines are set by the Federal Rules of Bankruptcy Procedure, but each state has the right to set its own exemptions for Chapter 7 bankruptcy. For example, some states allow debtors to protect most of the equity in their home — called the homestead exemption — while other states offer no protections against losing a home. Other common exemptions are motor vehicles, personal belongings like jewelry and clothing, and retirement savings and pensions [source: Bulkat].
To further confuse things, there are also federal exemption rules, and some states allow you to choose between either the state or federal exemptions in a Chapter 7 bankruptcy. Did we mention you should hire a lawyer?
Bankruptcy laws don't solely exist to make your life difficult. They also establish important protections against aggressive creditors. Once you have filed for either Chapter 7 or 13 bankruptcy, your creditors are barred from trying to collecting on your debt or filing a lawsuits against you. One of the advantages of Chapter 13 bankruptcy is that even if you've missed mortgage payments and your home is in foreclosure, you get an automatic stay. As part of the repayment plan, you can make up for missed payments and save your house.
For lots more information about debt management, debt relief and staying out of the red, check out the related HowStuffWorks articles on the next page.
Author's Note: How to Declare Bankruptcy
About 2,500 people and businesses declare bankruptcy each day in America. Last year, that added up to nearly 1 million people who became so overwhelmed by debt that they were willing to put a black mark on their credit reports for a decade in exchange for a fresh start. My heart goes out to families who suffer through a financial calamity that leads to foreclosure or bankruptcy. I'm grateful to know that in cities throughout the country, there are free legal aid organizations in which bankruptcy lawyers provide pro bono services to low-income community members. Lawyers get a bad rap, but I've personally known several attorneys who volunteer a significant amount of their time to helping folks navigate the legal bureaucracy and get their lives back in order.
- Bulkat, Baran. "California Bankruptcy Exemptions." Nolo (Sept. 26, 2014) http://www.nolo.com/legal-encyclopedia/california-bankruptcy-exemptions-property-assets.html
- Federal Trade Commission. "Debt Collection" (Sept. 26, 2014) http://www.consumer.ftc.gov/articles/0149-debt-collection
- FICO. "Chapter 7 & 13: How long will negative information remain on my credit report?" (Sept. 26, 2014) http://www.myfico.com/crediteducation/questions/negative-items-on-credit-report-chapter-7-13.aspx
- Maidman, Bret. A. "Chapter 11 Bankruptcy: An Overview." Nolo (Sept. 26, 2014) http://www.nolo.com/legal-encyclopedia/chapter-11-bankruptcy-overview.html
- New York Fed. "New York Fed Report Shows Rises in Auto Loan Origination and Balances." Aug. 14, 2014 (Sept. 26, 2014) http://www.newyorkfed.org/newsevents/news/research/2014/an140814.html
- Nolo. "Alternatives to Bankruptcy" (Sept. 26, 2014) http://www.nolo.com/legal-encyclopedia/bankruptcy-alternatives-30011.html
- U.S. Courts. "Bankruptcy Basics, Part 4: Filing for Bankruptcy" (Sept. 26, 2014) http://www.uscourts.gov/Multimedia/Videos.aspx?video_url=http://www.uscourts.gov/video/source/BankruptcyBasics/bankruptcy-eng_4-filing_low.f4v&video_image=/uscourts/video/BankruptcyBasics/images/preview4.jpg&video_id=bb4
- U.S. Courts. "Individual Debt Adjustment" (Sept. 26, 2014) http://www.uscourts.gov/FederalCourts/Bankruptcy/BankruptcyBasics/Chapter13.aspx
- U.S. Courts. "Liquidation Under the Bankruptcy Code" (Sept. 26, 2014) http://www.uscourts.gov/FederalCourts/Bankruptcy/BankruptcyBasics/Chapter7.aspx
- U.S. Courts. "Table F-2: U.S. Bankruptcy Courts — Business and Nonbusiness Cases Commenced, by Chapter of the Bankruptcy Code, During the 12-month Period Ending June 30, 2014" (Sept. 26, 2014) http://www.uscourts.gov/uscourts/Statistics/BankruptcyStatistics/BankruptcyFilings/2014/0614_f2.pdf