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Bankruptcy: What Is It, and How Does It Work?

Bankruptcy may seem like a quick fix, but it can have a lasting negative effect.

Author Justin Cupler
Contributing Writer at Tally
April 20, 2021

Bankruptcy is older than the U.S. itself, but Congress passed the first-ever bankruptcy code in 1800. This initial law was skewed toward the creditor, allowing them to force involuntary bankruptcy upon debtors. This law lasted only three years before being repealed. 

Bankruptcy returned in 1837 as a new law that more closely resembles today’s debtor-friendly bankruptcy laws

What is bankruptcy today? It’s a last-resort option when the United States courts step in to offer debt relief. Whether it’s racked-up credit card debt, suffocating medical bills, or secured loans you can no longer afford, bankruptcy can help right your financial ship. It does, however, come with consequences, which we will get to later. 

You might be wondering, “How does bankruptcy work?” To help, we’ll cover bankruptcy basics, its drawbacks, and alternatives.

What are the types of bankruptcy?

Bankruptcy: A couple uses a calculator and looks over their finances

Individuals generally file one of two types of bankruptcy: Chapter 7 and Chapter 13. There is also a Chapter 11 bankruptcy, but that is for businesses, so our focus is on Chapters 7 and 13. 

Chapter 7 bankruptcy

Chapter 7 bankruptcy, also known as liquidation bankruptcy, is the most severe of the two options, but it is also the quickest path to ridding yourself of unaffordable debts. 

Under Chapter 7 bankruptcy, not every debt is eligible for discharge, meaning the creditor forgives the debt after the bankruptcy process is complete, including: 

  • Alimony and child support
  • Certain unpaid state and federal taxes
  • Restitution payments for malicious and willful injury to a person or property
  • Debt caused by death or injury to another person while driving under the influence of drugs or alcohol

Student loans and past income tax debts are also challenging to have discharged without displaying extreme hardship.

Once you file a Chapter 7 bankruptcy petition, there is an automatic stay, meaning all creditors you include for discharge must cease collection activity.

Chapter 7 bankruptcy eligibility 

Not everyone is eligible for Chapter 7 bankruptcy, as you must earn less than the state’s mean monthly income to qualify automatically. If you exceed this monthly income, you’re subject to the means test to determine if your income and debts qualify you for this program. 

You pass the means test if your income over the next five years is less than $12,500 per month after allowed expenses or if your income over the next five years is less than 25% of your “nonpriority debt unsecured debt,” like credit cards and personal loans. You can challenge a means test failure, but failing the means test usually results in the courts converting your case to Chapter 13 bankruptcy

You can use bankruptcy form 122A-1 to determine if your income Is under the state median. If you’re over the state median income, you’d then use bankruptcy form 122A-2 to see if you pass the means test.

How Chapter 7 bankruptcy works

In Chapter 7 bankruptcy, a court-appointed bankruptcy trustee will liquidate — sell at a price that’s generally lower than their market value — some or all of your assets, including your home, cars, collectibles, personal goods, and more. The trustee uses the proceeds from the liquidation to pay your creditors. 

There are some exceptions to the liquidation process known as exemptions. The exemptions vary by state, but they generally include: 

  • Automobile up to a predetermined value
  • Necessary clothing
  • Necessary household goods and furniture
  • Home appliances
  • Jewelry up to a predetermined value
  • Pensions
  • Home equity up to a predetermined value
  • Trade tools up to a predetermined value

To prevent these items from being liquidated, you must file a schedule of exempt property and seek court approval to have them exempted. 

The trustee will hold a meeting of creditors 21 to 50 days after a debtor files Chapter 7 bankruptcy. At this meeting, the debtor must answer questions about their financial affairs from their creditors and the trustee while under oath.

Within 10 days of the meeting, the trustee will tell the courts whether they feel the debtor’s situation doesn’t pass the means test. If the debtor doesn’t pass the means test in the trustee’s eyes, the debtor may convert to Chapter 13 or withdraw their bankruptcy petition. 

If the trustee confirms the debtor passes the means test in their eyes, they will turn over all nonexempt property for liquidation. 

Once the trustee liquidates your nonexempt assets and distributes the funds to your creditors, your bankruptcy is typically discharged. This means you are officially free of all your debt obligations, and your former creditors can no longer contact you in an attempt to collect the debt. More than 99% of Chapter 7 bankruptcies end in discharge.  

It generally takes three to five months to complete Chapter 7 bankruptcy and have your debts discharged.

Keeping financed assets after bankruptcy

There are cases where a debtor can reaffirm a debt, keeping it from being discharged and allowing them to keep the asset. This is generally only an option on a secured debt, like a mortgage or an automobile. 

Reaffirmation is a negotiation between the creditor and debtor, and the creditor will have the right to repossess the asset if the debtor fails to adhere to the agreed-upon reaffirmation terms. This agreement must be in place before discharge. 

Chapter 13 bankruptcy

Bankruptcy: A closeup of two people reviewing paperwork

Chapter 13 bankruptcy is the alternative to Chapter 7. Instead of liquidating your assets to pay as much of your debts as possible and discharging the rest, it’s a debt reorganization that puts you on a three- to five-year repayment plan

Chapter 13 eligibility

Chapter 13 bankruptcy has far fewer eligibility restrictions than Chapter 7. Its main eligibility requirement is that the debtor has less than $394,725 in unsecured debt and less than $1,184,200 in secured debt

The debtor also can’t file for Chapter 13 without receiving credit counseling from an approved agency within 180 days of filing. This counseling can be a one-on-one meeting or in a group setting. 

Also, a debtor can’t file for Chapter 13 if a previous bankruptcy filing was dismissed within the past 180 days due to them willfully failing to appear before the court or comply with court orders. A debtor is also not eligible to file for Chapter 13 for 180 days if they requested for the dismissal of a previous bankruptcy case after creditors sought relief from the bankruptcy courts to recover property.

How Chapter 13 bankruptcy works

In Chapter 13 bankruptcy, the court-appointed trustee reviews your current and anticipated future income, guides the bankruptcy process, speaks with creditors, and distributes payments to creditors.

The debtor will work with the trustee, their lawyer, and sometimes a credit counselor to create and submit a debt repayment plan for court approval within 14 days of filing. The plan’s terms depend on the debtor’s income. If their income is over the state median income, they’ll usually be on the five-year plan. If it’s under the state median income, then they’ll usually be on the three-year plan, unless there is just cause for putting them on the five-year plan. 

The plan must include regular payments — usually biweekly or monthly — to the trustee and an outline for getting the debtor’s secured debt, like their home mortgage or car loan provider, up to date to prevent foreclosure or repossession. The plan must show all the debtor’s disposable income — the money remaining from their income after paying all living expenses — going toward repaying debts.

The trustee will hold a meeting of creditors 21 to 50 days after a debtor files Chapter 13 bankruptcy. At this meeting, the trustee places the debtor under oath and they must answer questions about their financial affairs from their creditors and the trustee.

The meeting will also include a review and debate on the payment plan.

If any creditors have a problem with the proposed repayment terms, they can address them, and the debtor and trustee can make adjustments to meet creditors’ demands.

After the meeting, the debtor, creditors, and trustee will attend the official court hearing regarding the debtor’s Chapter 13 repayment plan. If the court approves the repayments terms, the debtor will make regular payments to the trustee, who will then distribute them to the creditors for the agreed-upon time frame.

Like Chapter 7, filing Chapter 13 bankruptcy stops all collection attempts from the debts you plan to discharge. Also, Chapter 13 bankruptcy discharges nearly all the same debts as Chapter 7. The only difference is Chapter 13 doesn’t discharge restitution for malicious property damage. Malicious injury to people is still not eligible for discharge. 

Chapter 13 payment hierarchy

Because all the creditors get paid from a single pool of cash the debtor pays, which is rarely enough to repay all the debts in full, there is a payment hierarchy in Chapter 13 bankruptcy

  • Priority claims: These are the most important payments in your Chapter 13 plan, and they include debts with special statuses, including taxes and student loans. Your Chapter 13 payments will pay these first.
  • Secured claims: Secured claims are for debts where the lender has a right to repossess property for nonpayment. If the debtor plans to keep the property, the total payments during the Chapter 13 plan must pay at least the value of the collateral. There are exceptions, such as secured loans taken too close to the bankruptcy filing. In these special cases, the debtor must often pay the entire financed amount — not just the value. A mortgage is another exception, as the debtor must repay this according to the original terms.
  • Unsecured claims: These are the lowest creditors on the repayment hierarchy. There is no prescribed amount of these debts the debtor must repay. Instead, the only requirements are that any of the debtor’s projected disposable income during the repayment period goes toward repaying these and that they receive at least as much as they would have in a Chapter 7 bankruptcy.  

What are the downsides to bankruptcy?

Bankruptcy stops all collection calls and allows you to get a fresh start in as little as three months. Sounds like a great plan, right? What we haven’t covered are the severe consequences that come with filing bankruptcy. We’ll cover those now.

Potential to lose everything

In Chapter 7 bankruptcy, the trustee will liquidate all non-exempt assets. For some people, this could be virtually everything they own, from video game systems to antique collections to your paid-off vehicle. 

​Sure, you can exempt things like your home and necessary clothing, but there are limits to the exemptions. 

​Upfront costs

You’re already in a challenging financial situation, but bankruptcy still costs money. 

Chapter 7 comes with a bankruptcy case filing fee, an administrative fee, and a trustee surcharge. Chapter 13 carries a bankruptcy case filing fee and an administrative fee. 

Debtors can pay these fees in four installments, spreading the burden out. Also, debtors whose income is less than 150% of the poverty level can apply to have the fees waived. 

And this is on top of the attorney fees, which can run $1,000 to $3,500 for Chapter 7 and $2,500 to $6,000 for Chapter 13. Don’t forget about the credit counseling fees. While many credit counselors are free, others can charge up to $79 for a debt management plan. 

Sticks to your credit report

Your credit report and FICO credit score are keys to your overall financial wellbeing, and bankruptcy puts a significant negative mark on them for a long time

A Chapter 13 bankruptcy will remain on your credit report for up to seven years, and a Chapter 7 bankruptcy will stick for 10 years. This can make it hard to get approved for loans and credit cards, and it can even impact your ability to rent a home or apartment. 

​Over those seven years, the impact lessens, but you must plan on it making a significant impact on your financial life for the next 7-10 years. 

What are my alternatives to bankruptcy?

A smiling woman sits back in her desk chair with her hands behind her head

Out-of-control debt can be overwhelming, and bankruptcy is a tempting offer. However, it comes with severe consequences and, in some cases, could take 3-5 years to complete. And after all that, it remains a negative mark on your credit report for 7-10 years. 

Here are a few bankruptcy alternatives that can help you rein in your debt.

Negotiate with your creditors

If they fear they’ll get pennies on the dollar in bankruptcy, your creditors may be willing to negotiate debt settlements with you to keep you out of bankruptcy. Contact each credit card company and explain your financial situation and options, and ask if they can offer you a settlement.

These settlements can come in many forms, including paying less than you owe, reducing interest rates, waiving past late payment fees, and more. 

After negotiating these terms, you can work them into a debt repayment plan, which we’ll cover next.

Debt repayment plan

Sometimes all you need is a little structure to get out of debt. While bankruptcy offers this structure, its tradeoffs are significant. Instead of filing for bankruptcy, why not create your own debt repayment plan using the debt avalanche or debt snowball

Both apply order to your debt repayment and can help accelerate your repayment timeline without the negative hit to your credit. The big difference is the debt avalanche will save you more money in interest, while the debt snowball offers quick, satisfying wins by paying off smaller debts first.  

Debt consolidation

Debt consolidation takes multiple debts and rolls them into one account with a lower interest rate and more predictable repayment terms. Debt consolidation can come in several forms, including:

Line of credit

A line of credit is another excellent way to pay off debts without filing bankruptcy. Tally’s line of credit1 offers you an interest rate that’s typically lower than most credit cards. You can use this line of credit to pay off your credit cards, saving you on interest in the process. And since it’s a revolving line of credit, you can use it multiple times to pay off all your debts. 

Tally

Tally also offers automated payments to all your credit cards to avoid late fees and even has customized payoff plans to meet your needs. 

Bankruptcy: A last-resort option for unmanageable debt

A couple looks over their bills

While it can be a quick fix to your debt problems, bankruptcy also comes with a 7- to 10-year negative hit to your credit report. Along with that are fees for filing and attorney fees that can reach into the thousands of dollars. 

For some people, bankruptcy may be the only option. For most, though, there are other options, including: 

  • Negotiating with your creditors
  • Creating your own debt repayment plan
  • Taking out a debt consolidation loan
  • Opening a line of credit

While these options may not have the quick-fix feel of bankruptcy, they offer a path to a debt-free life without the high fees and negative information on your credit report.

1To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) Will be between 7.9% – 25.9% per year, and will be based on your credit history. The APR will vary with the market based on the Prime Rate.