If you are severely behind on your bills and all other debt management plans have failed, the last option available is declaring Bankruptcy.
What is Bankruptcy?
Bankruptcy is a type of forced debt settlement, and is a legal procedure. When you declare bankruptcy, the courts will gather all your unsecured creditors together, and hear the debts you owe. They will then examine all your assets, and pay out as much as they can to settle as many debts as possible.
How this happens will depend on the type of bankruptcy you declare, but once the courts have established the total repayment, all outstanding balances are discharged, and your creditors can make no more attempts to collect from you. This does not apply to all your debts – just most unsecured loans. Mortgages, car loans, and student loans cannot be discharged through bankruptcy.
The types of bankruptcy are named after the “Chapters” they are found in the Bankruptcy Code. Most of the “chapters” are just general rules (or are types of bankruptcy specifically for farms or businesses). There are two types of bankruptcy that an individual can apply for: Chapter 7 and Chapter 13.
Bankruptcy and Credit
Filing bankruptcy will discharge your debts, but it will also destroy your credit. A bankruptcy will remain on your credit report for the longest allowable amount of time – usually between 7 and 10 years. During that time (and especially for the first 3 years), it will be extremely difficult to get any new lines of credit.
This includes credit cards, but it also applies to car loans, and even trying to rent an apartment. If a creditor is willing to lend to you (or rent to you), there will be extremely high security deposits. Bankruptcy is an option available only after every other debt management plan has failed.
Chapter 7 Bankruptcy
Chapter 7 Bankruptcy is also called “Straight Bankruptcy”. It is the fastest and most direct way to go bankrupt, usually taking about 6 months from start to finish.
If you declare Chapter 7 Bankruptcy, you will be assigned a trustee, who will be responsible for managing all your debts. The trustee’s job is to sell off your assets to pay off as much of your debt as possible. This includes your bank accounts, your property, any investments, and even any of your “stuff” with a significant market value. Once your trustee gets together as much cash as possible from the sales and your bank accounts, they divide that cash between your creditors. Any remaining debt is discharged – your creditors cannot attempt to collect any more.
To be eligible for a Chapter 7 bankruptcy, you need to pass a “means test”. This means you need to earn less than the median income in your area to qualify. If you are too rich, Chapter 7 is not an option.
You also need to have unsecured debt, not including student loans. This means if all of your debt is from your mortgages, car loans, and payday loans secured by a title, Chapter 7 will not help – these creditors will simply seize all of the collateral, discharging your debt.
You will also be required to undergo credit counselling and credit education classes as part of the proceedings.
Chapter 7 bankruptcy only applies to unsecured debt, like credit cards and medical bills (but not student loans). If you have secured debt, like a mortgage, there is no bankruptcy protection. This is because secured debt has collateral – if you fall behind on your mortgage payments, your bank will simply foreclose on your house (selling it at the market price, taking any outstanding loan balance and giving you whatever is left).
Chapter 7 and Your Home
With a Chapter 7 bankruptcy, the trustee has full authority to sell off your home, or other property, to settle your other debts. However, just because they can does not mean they will.
Every state has different “Exemption” laws – things that cannot be taken away when you declare bankruptcy. No state completely protects your home, but they might say that at least $60,000 of your home’s value is protected. In this case, if the trustee sells your home, they need to give you $60,000 of the proceeds before distributing to other creditors.
But wait, it gets more complicated!
Remember – your mortgage is not part of the bankruptcy debt. This means if the trustee sells your house, they need to pay you the exemption amount first, then pay off the remaining balance of your mortgage, and only use the remaining piece to pay off the other creditors. If the trustee is not going to get anything from the sale of the home (after paying the mortgage, giving your exemption, and paying all sales/closing costs), they will not bother, and you can keep your home.
Chapter 7 and Foreclosure
In practice, this is fairly rare. If you are so far behind on your other bills that bankruptcy is the only option, you will probably be behind on your mortgage too, so the bank may already be looking at foreclosure. If the bank forecloses or your trustee sells the home, you are left in the same position.
Chapter 13 Bankruptcy
Chapter 13 Bankruptcy is also called a “Restructuring”. A Chapter 13 bankruptcy is a much longer process, usually taking between 3 and 5 years to finalize.
With a Chapter 13 filing, you are not assigned a trustee, and your assets are not all sold off. Instead, you are mandated to create a Payment Plan, and submit it to the court for approval. Then, for a period of either 3 or 5 years, most of your income will go directly to the court, which then distributes it to your creditors according to the plan. After the time is up, any remaining debt is cancelled.
This might sound like a sweet deal, but your creditors will always get at least what they would have been paid in the case of a Chapter 7 bankruptcy. The Chapter 13 is mostly an option for people with higher incomes and homes with more equity, and want to make sure they do not lose their homes.
You will need to earn more money for a Chapter 13 bankruptcy, and there is a similar test as the Chapter 7. Basically, the income you make over the course of the 3-5 year period needs to be greater than what a trustee would get by simply selling off your assets.
Like the Chapter 7 requirements, Chapter 13 also requires credit counselling and education.
A Chapter 13 Bankruptcy is designed to keep all your assets in-tact, without mass sell-offs or liquidation. This means that your mortgage and car payments will be unaffected – you will keep making them normally, and will retain ownership of your home.
Your Payment Plan
Your Payment Plan is the center of the Chapter 13 filing. Your payment plan is a summary of all your “Disposable Income” per month, and how that income will be divided between your creditors.
In this case, “Disposable Income” means all of your net income, minus “reasonable living expenses”. Reasonable living expenses includes all the payments of your Secured Debt (like your mortgage), plus some amount to cover food and other small bills. Once you have a payment plan, you will submit it to the courts for approval. Your creditors can object to how much you plan to pay them, but the final word is with the judge.
All of your disposable income is then paid directly to the courts, who distribute it to your creditors according to your Payment Plan. In many cases, the amount will be automatically taken from your paycheck before you even see it, just to make sure you hold up your end of the bargain.