Basics of Bankruptcy: How to Know When it is Your Best Option

Basics of BankruptcyFor people who are really struggling with debt, there often comes a time when climbing the mountain back to fiscal solvency seems impossible. At that moment, bankruptcy may seem like the best way out.  And sometimes it is.  But it’s certainly not an easy way out, so it’s something that should only be entered into after careful thought and deliberation.

If you’ve explored all of your other options and you still don’t see a way out of debt, you should meet with a bankruptcy lawyer. There’s a lot of fear, shame, misinformation and uncertainty surrounding bankruptcy so it’s important to find competent counsel to advise you.

In general, all of your unsecured debts will be discharged (forgiven) in bankruptcy. Unsecured debts include any debts that aren’t attached to a collateral such as a home, car, etc. Credit cards, older taxes, medical debts, health club membership and utility bills are examples of unsecured debt. Certain debts such as recent taxes, student loans, and alimony are non-dischargeable, meaning you may still be responsible for the debt even after bankruptcy.

There are basically two types of bankruptcies for individuals:  liquidation and reorganization.  Liquidation bankruptcies are called “Chapter 7” and reorganization bankruptcies are known as “Chapter 13” (because of the section of federal law these are found in).

The “Chapter 7” Bankruptcy

The most common form of bankruptcy for individuals is Chapter 7, also known as “liquidation bankruptcy.” In each state, there are “exemption” laws that govern the amount of property you are entitled to keep through bankruptcy. The majority of people who file for Chapter 7 keep all of their property. A common concern and confusion about Chapter 7 is that many people falsely believe he or she will lose all of his or her assets through Chapter 7. If your assets fit into the exemption law of your state, you’ll be able to keep it. Of course, if you have $50,000 sitting in your checking account, you can’t claim Chapter 7 and keep all of that money. The Trustee would take the unprotected portion of your assets and “liquidate” or sell it then use the proceeds for the benefit of the creditors.

Prior to filing Chapter 7, you are required to complete government-approved credit counseling. This is a short online class that takes about 40 minutes to 1 hour. You are required to complete another class (also done online) after filing.

Once you file Chapter 7 bankruptcy, an “Automatic Stay” goes into effect which prohibits any further collection activities, including calls, letters and lawsuits. Approximately 30 – 45 days after filing of Chapter 7, you are required to attend a Meeting of Creditors. This meeting is with the Trustee assigned to your case. Despite popular belief, you do not need to appear in court or visit the judge. The meeting is brief and lasts about 5 – 10 minutes. Creditors can also appear at the meeting, but this is rare.

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60 days after your Meeting of Creditors, assuming there are no objections or issues that arise in your case, an Order of Discharge will be entered. This means that your debts are forgiven. As mentioned above, some debts will remain, including any debts for child support, recent taxes, or student loans.  And of course, once all the bankruptcy proceedings are over, the bankruptcy will show on your credit report for up to 10 years. This does not mean that you will not be able to obtain credit for 10 years. For example, you can be considered for an FHA mortgage 2 years after Chapter 7 bankruptcy.

The “Chapter 13” Bankruptcy

Conversely, in a Chapter 13 bankruptcy, you would file a “repayment proposal” with the court which would outline a plan for paying off a portion of your debts. In general, you would make a monthly payment for 3 – 5 years to the Trustee, who will take those funds and distributed it to your creditors.

Unlike Chapter 7, which has no debt limit, Chapter 13 has debt limits. For secured debt, the limit is $1,081,400 and unsecured debts are capped at $365,475. Also, you need an income or some other source of money to fund your monthly payment.

You may consider Chapter 13 over Chapter 7 for various reasons. Some of the most common reasons include:

  • Behind on your mortgage or car payments. Chapter 13 gives you up to 5 years to “catch-up” on your missed payments so you can save the property from repossession or foreclosure.
  • Owe recent/new taxes. Older taxes can be discharged in bankruptcy. If you owe a lot of recent taxes, again, Chapter 13 allows you up to 5 years to repay it, and stops the accrual of interest and penalties.
  • Income is too high. Unlike Chapter 7, which has a income limitation, Chapter 13 doesn’t. So, if your income is too high for Chapter 7, you might file Chapter 13.
  • Too many assets. If you have assets that cannot be protected through Chapter 7, Chapter 13 may be ideal. In Chapter 13, instead of having your assets liquidated, you repay whatever the Chapter 7 trustee would have paid – known as “liquidation analysis.”

In Chapter 13, debts are repaid in order of priority. Meaning, certain debts like taxes, mortgage, car payments will be repaid first before unsecured debts. The amount you’ll have to repay in Chapter 13 depends on various factors including your income, expenses, types of debts, and liquidation analysis. This type of bankruptcy will stay on your credit report for 7 years from the date of filing.

The bottom line is that every person’s situation is unique.  If you are struggling with severe debt problems, and considering bankruptcy, you should always talk to a bankruptcy attorney who can advise you on the proper course of action.  For some people, bankruptcy will be the best option, while for others it just doesn’t make sense.  You can visit National Association of Consumer Bankruptcy Attorneys’ (NACBA) website for a bankruptcy attorney near you.

Image 1 credit: thetorpedodog
Image 2 credit: Josef Grunig

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