What Really Happens When You File for Bankruptcy

April 17, 2020
From: twocents.lifehacker.com
By: Kristin Wong and Lisa Rowan

Bankruptcy is a last resort for people and businesses alike. Many companies file for bankruptcy and continue business as usual; the lesser-known reality is that individuals can file for bankruptcy and emerge in one piece, too.

Bankruptcy is poorly understood, so let’s talk about how it affects your finances.

The differences between chapter 7, 13, and 11

In general, people file for bankruptcy when there’s no way in hell they can meet their debt obligations. Popular assumption is that those people are bad with money and take out too much credit card debt. Sure, that happens, but often, people file bankruptcy after a major financial blow. It might be a lawsuit debacle or an unexpected illness.

A lot of people think bankruptcy wipes out any and all debt obligations, but that’s not the case. You still have to pay up, and how you’ll pay up depends on what kind of bankruptcy you file: chapter 7, chapter 13, or chapter 11. There are other types of specific bankruptcies, too (chapter 12 is for farmers and fishermen, for example), but these three are the most common.

With chapter 7, you may have to liquidate certain assets (like a car or a second home) to pay off at least some of the debt. Most of your assets are probably exempt, but it depends on your state, your financial situation, and whether or not that asset is deemed “essential.” You have to meet certain eligibility requirements to file, and income is perhaps the most important one. As legal site Nolo explains, there’s a whole set of criteria to determine your income eligibility, but generally, you have to have little to no disposable income.

With chapter 13, you get a plan to pay off your debts within the next three to five years, but you get to keep your assets. After it’s all said and done, some of those debts will likely be discharged. You have to qualify, though, and that means your secured debts can’t be more than $1,184,200 and your unsecured debts cannot be more than $394,725. Secured debt is debt that’s backed by collateral, like your house or car.

Chapter 11 bankruptcy works kind of like chapter 13, but it's typically reserved for businesses. Businesses can file for chapter 7 bankruptcy, too, but again, that means a liquidation of assets, so chapter 11 is usually a more attractive option. Companies get to keep their stuff and keep their creditors at bay while they continue their operations, but they have to come up with a plan to pay off at least some of their debt, or get it forgiven.

What happens when you file

When you file for bankruptcy, you get an automatic stay. Basically, this puts a block on your debt to keep creditors from collecting. While the stay is in place, they can’t garnish your wages, deduct money from your bank account, or go after any secured assets.

Ironically, bankruptcy isn’t free. The filing fee alone is between $300 and $350 for chapters 7 and 13. And then there are the attorney fees. You can file without a lawyer, but it’s not recommended since bankruptcy laws can be tough to navigate. Attorney fees for chapter 7 average around $1,500, while chapter 13 fees tend to be in the $2,000-$3,000 range. With many attorneys, the more complex your situation, the more you’ll pay.

There are ways reduce the legal costs of filing for bankruptcy. Nonprofit Upsolve, for one, helps you generate your bankruptcy filing forms for free if your case is a simple one. Or, your local legal aid society may be able to connect you with low-cost legal services.

You’ll also have to take a class or two. The government requires individuals to get credit counseling 180 days before you file, and you also have to take a debtor education course if you want your debts discharged.

A couple of weeks after filing, you’ll have to attend a “creditors meeting,” which is basically what it sounds like: a court meeting between you, your bankruptcy trustee, and any creditors who want to attend. They’ll all ask you questions about your financial situation and decision to file bankruptcy.

Your assets get liquidated with chapter 7

Nolo says that in most cases, chapter 7 debtors don’t have to liquidate their property (unless it’s collateral) because it’s usually exempt or it’s just not worth it. They explain:

If the property isn’t worth very much or would be cumbersome for the trustee to sell, the trustee may “abandon” the property — which means that you get to keep it, even though it is nonexempt...Most property owned by Chapter 7 debtors is either exempt or is essentially worthless for purposes of raising money for the creditors. As a result, few debtors end up having to surrender any property, unless it is collateral for a secured debt…

After the creditors meeting, your trustee will figure out whether or not to liquidate your stuff. If it does get liquidated, that means you’ll have to either surrender it or fork over its equivalent cash value to pay back your debt.

You get a payment plan with chapter 13

With chapter 13, you get a plan to pay off your debts, and some of them have to be paid in full. These debts are “priority debts,” and they include alimony, child support, tax obligations, and wages you owe to employees.

Your plan is based on how much you owe and what your income looks like, and it will include how much you have to pay and when you have to pay it.

What happens to your credit

Your credit score will plummet with a bankruptcy. The higher your score, the more it’ll fall. FICO notes that the more accounts are involved in your bankruptcy filing, the greater an impact you’ll see to your score.

In general, chapter 7 bankruptcy remain on your credit report for 10 years, and chapter 13 stays on for seven.

After bankruptcy is all said and done, most debts are discharged, but not all of them.

In some cases, student loans can be discharged after a bankruptcy, but you have to pass a federal test for hardship.

Other difficult-to-discharge debts include:

• Tax debts
• Alimony and child support
• Divorce-related debts, including property settlement debts

Bankruptcy is usually a desperate remedy to a helpless situation. But knowing how it works and what to expect can help you navigate some of the misconceptions and figure out what the process actually entails.

This post was originally published in 2016 and was updated on 4/17/2020 by Lisa Rowan. Updates include: Checked links for accuracy; updated formatting to reflect current style; revised article to focus on bankruptcy methods for individuals; updated monetary requirements and averages.