Bankruptcy Explained: Types and How It Works

What Is Bankruptcy?

Bankruptcy is a legal proceeding initiated when a person or business cannot repay outstanding debts or obligations. It offers a fresh start for people who can no longer afford to pay their bills.

The bankruptcy process begins with a petition filed by the debtor, which is most common, or on behalf of creditors, which is less common. All of the debtor's assets are measured and evaluated, and the assets may be used to repay a portion of the outstanding debt.

Key Takeaways

Bankruptcy is a legal proceeding carried out to free individuals or businesses from their debts.
Creditors still have an opportunity for repayment with the bankruptcy process.
Bankruptcy is handled in federal courts, and rules are outlined in the U.S. Bankruptcy Code.
A bankruptcy will stay on your credit reports for a number of years, making it more difficult to borrow in the future.

How Bankruptcy Works

Bankruptcy offers an individual or business a chance to start fresh by forgiving debts that they can't pay. Meanwhile, creditors have a chance to get some repayment based on the individual's or business's assets available for liquidation.

In theory, the ability to file for bankruptcy benefits the overall economy by allowing people and companies a second chance to gain access to credit. It can also help creditors regain a portion of debt repayment.

All bankruptcy cases in the United States go through federal courts. A bankruptcy judge makes decisions, including whether a debtor is eligible to file and whether they should be discharged of their debts.

Administration over bankruptcy cases is often handled by a trustee, an officer appointed by the United States Trustee Program of the Department of Justice, to represent the debtor's estate in the proceeding. The debtor and the judge usually have no contact unless there is some objection made in the case by a creditor. When bankruptcy proceedings are complete, the debtor is relieved of their debt obligations.

What Are the Types of Bankruptcy Filings?

Bankruptcy filings in the United States are categorized by which chapter of the Bankruptcy Code applies. For example, Chapter 7 involves the liquidation of assets, Chapter 11 deals with company or individual reorganizations, and Chapter 13 arranges for debt repayment with lowered debt covenants or specific payment plans.

Bankruptcy filing costs vary, depending on the type of bankruptcy, the complexity of the case, and other factors.

Chapter 7 Bankruptcy

Most people file for Chapter 7 bankruptcy, which allows you to dispose of unsecured debts, such as credit card balances and medical bills.

You must liquidate property to repay some or all of your unsecured debts if you have nonexempt assets, such as family heirlooms (collections with high valuations, like coin or stamp collections), second homes, or investments like stocks or bonds.

When you file Chapter 7 bankruptcy, you essentially sell off your assets to clear debt. People who have no valuable assets and only exempt property—such as household goods, clothing, tools for their trades, and a personal vehicle worth up to a certain value—may end up repaying no part of their unsecured debt.

Chapter 11 Bankruptcy

Businesses often file for Chapter 11 bankruptcy, with the goal of reorganizing and remaining in business. Filing Chapter 11 bankruptcy gives a company the opportunity to create plans for profitability, cut costs, and find new ways to increase revenue. Its preferred stockholders, if any, may still receive payments, though common stockholders will be last in line.

For example, a housekeeping business filing Chapter 11 bankruptcy might increase its rates slightly and offer more services to become profitable. Chapter 11 bankruptcy allows the business to continue conducting its business activities without interruption while working on a debt repayment plan under the court's supervision. In rare cases, individuals can also file for Chapter 11 bankruptcy.

Chapter 13 Bankruptcy

Individuals who make too much money to qualify for Chapter 7 bankruptcy may file under Chapter 13, also known as a wage earner's plan. It allows individuals—as well as businesses, with consistent income—to create workable debt repayment plans.

The repayment plans are commonly in installments over the course of a three- to five-year period. In exchange for repaying their creditors, these debtors are allowed, per the courts, to keep all of their property, including otherwise nonexempt property.

Other Bankruptcy Filings

While Chapter 7, Chapter 11, and Chapter 13 are the most common bankruptcy proceedings, there are several other types:

Chapter 9 bankruptcy is available to financially distressed municipalities, including cities, towns, villages, counties, and school districts. Under Chapter 9, municipalities do not have to liquidate assets to repay their debts but are instead allowed to develop a plan for repaying them over time.
Chapter 10 bankruptcy, which effectively ended in 1978, was a form of corporate bankruptcy that has been supplanted by Chapter 11.
Chapter 12 bankruptcy provides relief to family farms and fisheries. They are allowed to maintain their businesses while working out a plan to repay their debts.
Chapter 15 bankruptcy was added to the law in 2005 to deal with cross-border cases, which involve debtors, assets, creditors, and other parties that may be in more than one country. This type of petition is usually filed in the debtor's home country.

Being Discharged From Bankruptcy

When a debtor receives a discharge order, they are no longer legally required to pay the debts specified in the order. What's more, any creditor listed on the discharge order cannot legally undertake any type of collection activity (such as making phone calls or sending letters) against the debtor once the discharge order is in force.

However, not all debts qualify to be discharged. Some of these include tax claims, anything that was not listed by the debtor, child support or alimony payments, personal injury debts, and debts to the government. In addition, any secured creditor can still enforce a lien against property owned by the debtor, provided that the lien is still valid.

Debtors do not necessarily have the right to a discharge. When a petition for bankruptcy has been filed in court, creditors receive a notice and can object if they choose to do so. If they do, they will need to file a complaint in court before the deadline. This leads to the filing of an adversary proceeding to recover money owed or enforce a lien.

The discharge from Chapter 7 is usually granted about four months after the debtor files a petition for bankruptcy. For any other type of bankruptcy, the discharge can occur when it becomes practical.

Advantages and Disadvantages of Bankruptcy

Declaring bankruptcy can help relieve you of your legal obligation to pay your debts and save your home, business, or ability to function financially, depending on which kind of bankruptcy petition you file. But it will also lower your credit rating, making it more difficult to get a loan, mortgage, or credit card, buy a home or business, or rent an apartment.

If you're trying to decide whether you should file for bankruptcy, your credit is probably already damaged. But it's worth noting that a Chapter 7 filing will stay on your credit report for 10 years, while a Chapter 13 will remain there for seven. Any creditors or lenders you apply to for new debt (such as a car loan, credit card, line of credit, or mortgage) will see the discharge on your report, which can prevent you from getting any credit.

Bankruptcy Pros and Cons

Pros

Allows debtors to emerge from default
Wipes clean certain unsecured debts
Avoids legal judgment

Cons

Leaves a scar on one's credit score
Secured debts will have the collateral seized
Certain debts like child support are not eligible for discharge

Alternatives to Bankruptcy

If you want to avoid bankruptcy, several alternatives may be able to reduce your debt obligations.

Negotiating with your creditors without involving the courts can sometimes work to the benefit of both sides. Rather than risk receiving nothing, a creditor might agree to a repayment schedule that reduces your debt or spreads your payments over a longer period of time.

If you are unable to make your mortgage payments, it's worth calling your loan servicer to find out what options you might have, short of filing for bankruptcy. Those could include forbearance, which will allow you to stop making payments for a specified time, or a repayment plan designed to stretch smaller monthly payments over a longer period.

Another option might be loan modification, which will change the terms of your loan (such as lowering the interest rate) on a permanent basis, making it easier to repay. However, beware of unsolicited offers from companies claiming that they can keep your home out of foreclosure. They may be nothing more than scam artists.

If you owe tax money to the IRS, you may be eligible for an offer in compromise, allowing you to settle with the agency for an amount less than you owe. In some instances, the IRS also offers monthly payment plans for taxpayers who can’t pay their tax obligations all at once.

What Is the Downside of Filing for Bankruptcy?

One downside of filing for bankruptcy is an immediate large and negative impact on your credit score. Bankruptcy will remain on your credit report for seven to 10 years. As a result, it will be more difficult and more costly to borrow money. Depending on the type of bankruptcy, you could lose assets like your home and car.

Is Bankruptcy a Good Choice?

For some people or businesses, unfortunately, bankruptcy is the right choice. If debts become too large to manage, the alternative could be a liquidation of all of your assets and legal judgments for non-payment or breach of contract. While damaging to your credit and reputation, bankruptcy is a legal channel for avoiding this type of worst-case scenario.

Do You Get Out of All Your Debts if You File for Bankruptcy?

Bankruptcy can renegotiate or erase many types of unsecured debts, such as those on credit cards or personal loans. Other debts cannot be discharged in bankruptcy. The U.S. Bankruptcy Code lists 19 different categories of debts that cannot be discharged:

Alimony and child support
Certain unpaid taxes, such as tax liens. However, some federal, state, and local taxes may be eligible for discharge if they date back several years
Debts for willful and malicious injury to another person or property (“Willful and malicious” here means deliberate and without just cause. In Chapter 13 bankruptcy, this applies only to injury to people; debts for property damage may be discharged.)
Debts for death or personal injury caused by the debtor’s operation of a motor vehicle while intoxicated from alcohol or impaired by other substances
Debts that you failed to list in your bankruptcy filing
Common/maintenance fees for condo association (or similar)

Will I Lose My Car if I Declare Bankruptcy?

If you bought your car with a loan, your vehicle may be seized as collateral during a bankruptcy proceeding. However, you can usually keep your car by reaffirming your car loan and continuing to make payments. Similarly, you can usually keep your home if you declare bankruptcy, even if you owe money on it, as long as you continue making payments and don’t have more equity than you are permitted under state and federal bankruptcy laws.

How Does One File for Bankruptcy?

Bankruptcy is a legal process, so it begins when the debtor files a petition with the relevant bankruptcy court. This is often achieved through the help of a lawyer specialized in these types of cases.

The Bottom Line

Bankruptcy can provide the financial benefit of wiping out debt you cannot pay and helping you start fresh, but there are consequences. Having a bankruptcy on your credit history can harm your credit score and make it more difficult to get loans in the future,

Before filing for bankruptcy, weigh all your options for resolving your debt, including a debt consolidation program and renegotiating the terms with your lender. Consider consulting a professional financial advisor who can review all the options and guide you through how they would work in your specific financial situation.