What is Bankruptcy and What Happens to My Credit?

Highlights:

• Filing for bankruptcy is a legal process for individuals and businesses that find themselves unable to pay their debts.
• There are generally two types of bankruptcy available to individuals: Chapter 7 and Chapter 13.
• Bankruptcy may help some borrowers get a handle on their debt; however, the process has long-term financial consequences that should be taken into consideration before filing.

If you’re buried in debt and struggling to repay what you owe, you may have considered filing for bankruptcy.

It’s true that bankruptcy may offer some borrowers the chance at a financial fresh start. But the process also comes with long-term financial consequences that should be considered carefully before filing.

What is bankruptcy?

Filing for bankruptcy is a legal process for individuals and businesses that find themselves unable to pay their debts. During bankruptcy proceedings, a court examines the filer’s financial situation, including their assets and liabilities.

If the court finds that the filer has insufficient assets to cover what they owe, it may rule that the debts be discharged, meaning the borrower is no longer legally responsible for them. Bankruptcy may also help borrowers address their debts by liquidating assets or creating a repayment plan.

Bankruptcy aims to give filers a financial fresh start. However, it’s not a decision to be taken lightly. A bankruptcy filing will appear on your credit report for seven to 10 years, during which time it can significantly lower your credit scores or make it challenging for you to secure new credit accounts.

Because of this, it’s important to only consider bankruptcy as a last resort after you’ve made other efforts to repay your debts.

Types of individual bankruptcy: Chapter 7 and Chapter 13

There are generally two types of bankruptcy available to individuals: Chapter 7 and Chapter 13.

What is Chapter 7 bankruptcy? Also known as liquidation bankruptcy, Chapter 7 is generally the more common of the two options. This type of bankruptcy offers forgiveness for qualifying debts. In exchange, you may be required to relinquish certain assets to a bankruptcy trustee, who will sell them and turn the funds over as partial payments to your lenders.

To qualify for Chapter 7, your income must be either at or below the median income for your state. If you earn more than this, you may be given a “means test” that compares your income over a six-month period to the amount of debt you owe.

You may also be asked to liquidate qualifying property to repay part of the debt. This might include stock investments, valuable collections, investment property or similar assets that could be used to repay your lenders.

Not all Chapter 7 filings will require you to liquidate qualifying property. Plus, many assets are exempt from being seized, including some equity in your home, the equipment you need for work, social security checks, retirement savings, pensions, welfare payments and other benefits. Exempt property varies depending on your location and your unique financial situation.

If approved for Chapter 7 bankruptcy, the following types of debt may be discharged:

• Credit card balances
• Medical bills
• Personal loans
• Income tax debt
• Private student loans (provided you can prove undue hardship)
• Mortgage or automobile loans (though you may be required to give up the related assets)
• Other unsecured debts

Other debts are typically not dischargeable under Chapter 7, including:

• Child support
• Alimony
• Federal student loans
• Tax liens
• Court fees

What is Chapter 13 bankruptcy? Often referred to as reorganization bankruptcy, Chapter 13 is less common than Chapter 7 and doesn't provide the same kind of forgiveness options. Instead, Chapter 13 allows you to hold onto your property while repaying your debt over time, typically within three to five years.

With Chapter 13 bankruptcy, instead of being discharged, your debts are reorganized with help from the courts and you’re able to present a payment program to address them. During this repayment period, creditors are blocked from pursuing collections for these outstanding debts.

Chapter 13 bankruptcy may provide less direct relief than Chapter 7 bankruptcy, but it also impacts your credit health for a shorter period of time. A Chapter 13 bankruptcy will appear on your credit report for up to seven years, while a Chapter 7 remains there for 10 years.

To qualify for Chapter 13 bankruptcy, you must prove that you have the means to keep up with monthly payments. You may also be required to complete a credit counseling course approved by the U.S. Trustee Program of the U.S. Department of Justice.

Before you consider filing for bankruptcy

Experts suggest working with a reputable credit counseling agency that can help you set up a budget, learn money management skills and create a debt management plan. Remember that bankruptcy carries significant long-term credit penalties and can make getting loans in the future very difficult. Also, most experts advise to talk to a bankruptcy lawyer if you decide to pursue filing for bankruptcy.

Part of understanding bankruptcy is knowing that it definitely affects your credit and future ability to use loans.

How much does it cost to file for bankruptcy?

The bankruptcy process is not free. Depending on your situation and the type of bankruptcy you’re looking to file, the cost can vary from hundreds to thousands of dollars.

Between filing and attorney fees, Chapter 7 bankruptcies can cost anywhere between $1,000 and $1,800. Chapter 13 fees are likely to be higher, ranging from $2,500 to $6,000.

If you cannot afford to file bankruptcy, free and low-cost legal aid options are available.

Additionally, Chapter 7 applicants who can’t afford filing fees can typically apply for a fee waiver. The bankruptcy court will then determine whether to waive the filing fees completely or allow you to pay in installments.

On the other hand, Chapter 13 bankruptcy filers are generally not granted fee waivers. The court may reason that anyone who cannot afford the application also won’t be able to make the debt payments required of a Chapter 13 bankruptcy.

What happens after you file for bankruptcy?

Once you’ve filed for bankruptcy, the process varies depending on the outcome of your case and the type of bankruptcy you filed. If your filing was successful, you may receive loan forgiveness or be given access to a repayment plan that can help you get back on track with your creditors. If you are denied for some reason, you may remain liable for your debts.

Also, remember that a bankruptcy will stay on your credit report for a significant period of time. Chapter 7 bankruptcies generally stay on your credit report for 10 years while Chapter 13 bankruptcies generally stay on your credit report for 7 years. During this time, you may find it more difficult to qualify for new credit accounts.

Bankruptcy can offer much-needed relief from debt, but there are consequences and it’s not a decision to be made lightly. As you emerge on the other side of a bankruptcy, it’s important to review your financial situation and keep careful track of your spending habits and any remaining loans, so that you can give yourself the best fresh start possible.