Bankruptcy is a legal proceeding for people or businesses unable to repay their outstanding debts. The two most common types of personal bankruptcy are Chapter 7 and Chapter 13 – named for chapters of the Federal Bankruptcy Code.
Filing for bankruptcy is generally considered a worst-case scenario because the results are so long-lasting and far-reaching: Bankruptcy can remain on your credit report for up to 10 years and make it difficult to obtain credit, buy or rent a home, get insurance or even a job.
It's also expensive and complicated: Chapter 7 bankruptcy can cost thousands of dollars in up-front lawyer's fees, plus fees for a court filing, mandatory credit counseling and budgeting courses, and Chapter 13 is even more expensive. Under Chapter 7 ("liquidation") bankruptcy, an administrator or trustee is appointed to sell most of your assets, aside from certain exempted necessities such as your primary residence, a car, clothing, home furnishings and work tools. Pensions and 401(k) accounts are usually protected as well.
Once assets are liquidated, the trustee distributes the proceeds to your unsecured creditors. In exchange, many unsecured debts, such as credit card and medical bills, are forgiven, or discharged. However, secured or fixed debts, such as mortgages, student loans, taxes, alimony and child support typically are not erased.
Eligibility for Chapter 7 is determined by a "means test," which requires you to confirm that your income does not exceed a certain amount (varies by state). The court uses the means test to determine whether or not you have sufficient money available to make at least minimal payments to creditors under a Chapter 13 plan. If you fail the means test your case will be dismissed or converted to a Chapter 13 filing. (To learn more about means testing, click HERE.)
Chapter 7 bankruptcy typically remains on your credit report for up to 10 years. Also, you must wait eight years after having debt discharged before being able to file Chapter 7 again.
Under Chapter 13 ("reorganization") bankruptcy, debtors with steady income are allowed to keep property they might otherwise lose, in exchange for agreeing to use future income to repay creditors over a three-to-five-year period. You are assigned a trustee with whom you develop a proposed debt repayment plan.
The bankruptcy court decides whether to accept or alter the plan, or to dictate another plan. After it's approved, both you and your creditors are bound by the plan's terms. Generally, you make payments to a trustee who in turn distributes the funds according to the plan's terms. Once all payments are completed, the court will formally grant a discharge of your debts.
Chapter 13 bankruptcy typically remains on your credit report for up to seven years. Also, you must wait at least two years after having debt discharged before being able to file Chapter 13 again.
Under bankruptcy law, before filing for bankruptcy you must first receive credit counseling from a government-approved organization within six months before filing. To find an approved credit counselor in your area, visit the U.S. Trustee Program at www.usdoj.gov/ust.
In addition, after filing but before your debt is discharged, you must also complete an approved debtor education program (go to www.justice.gov/ust/eo/bapcpa/ccde/de_approved.htm to find one). You must receive certificates of completion from each program in order to proceed with your bankruptcy.
If you are interested in learning more about personal bankruptcy, view the Khan Academy video.