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Updated April 25, 2016
The information contained in this page is for general purposes only. Each situation, including your own, is unique, and the law may apply differently to you.
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What is Bankruptcy?
Bankruptcy is a form of economic relief from debts provided for under federal law. It allows a debtor to make a "fresh start," to either discharge or restructure payment of his debts owing to his creditors. Through bankruptcy, a debtor is relieved of the stress and pressure associated with collection efforts brought by creditors, and creditors may be assured repayment of at least part of the debts though the agency of a trustee.
What types of bankruptcy relief are available?
There are two main types of individual consumer bankruptcy relief, Chapter 7 and Chapter 13.
In its simplest form, Chapter 7 bankruptcy provides for liquidation of the debtor's assets and distribution of their value among the creditors. Creditors divide the assets among themselves according to the priority classification of the debt, and they receive a return on the debt in accordance with the amount of assets liquidated. In the event that the debtor has little or no assets to liquidate, the creditors' return on the debts is zero. Upon discharge, the debt is no longer owed. In practice, most, if not all, of a debtor's assets can be exempted from administration by the Trustee, creating a "no asset" case. The amounts of exemptions for specified kinds of property change from time to time, so it is important to know what is allowed and what is not.
Chapter 13 bankruptcy, by contrast, allows a debtor to restructure his debt and pay the debt back to many of his creditors over a three to five year period. The debtor's income is analyzed, and a financial plan is drafted and approved by the court that allows him to repay his excess monthly income to a trustee appointed by the court. The trustee, in turn, distributes the excess income to the creditors, again in accordance with their priority classification. Some types of debt can be discharged without repayment through the plan. At the end of the repayment period, the debts are no longer owed.
Other types of bankruptcy allow relief for farmers and for business, but are not discussed on this site.
What is the procedure for seeking relief in bankruptcy?
New rules for filing bankruptcy went into effect in October 2005, making the process of filing for bankruptcy more difficult. First, the individual must participate in debt counseling offered by one of several organizations approved by the local bankruptcy court. The counseling sessions generally have a fee. If a reasonable budget plan cannot be drawn up, then a Petition for Relief may be filed in the local bankruptcy court, specifying the type of relief sought. Numerous schedules attached to the petition provide a "snapshot" of the debtor's financial health, describing in detail his or her assets, debts, income and expenses. The debtor also submits a "means test calculation" whereby the average monthly income is compared to the regional median income. The results of the calculations generally determine whether the debtor may file for protection under chapter 7 or chapter 13, and if the latter, how long the repayment plan should be. The debtor's assets that are not exempted become part of the bankruptcy estate, which is assigned to a trustee. Further information regarding recent transactions and property transfers is also required. In a Chapter 13 petition, a repayment plan is also included.
After the petition is filed, all collection activities by the creditors must cease. The court schedules a Meeting of Creditors before the trustee, and gives notice to the parties and creditors, allowing them the opportunity to raise objections to the discharge of the debts. In a Chapter 13 bankruptcy, monthly payments in accordance with the plan are made to the trustee. In a Chapter 7 bankruptcy, if no objections to discharge are raised within 60 days following the meeting of creditors, the trustee recommends discharge to the bankruptcy judge. Following the meeting of creditors in a Chapter 13 bankruptcy, the case is scheduled for a hearing before the bankruptcy judge for final approval of the repayment plan. Before and during this period, creditors may file claims against the estate. If the repayment plan is adequate enough to meet all the requirements, the plan is approved, and regular monthly payments continue for the length of the plan.
Will I lose everything I own in a bankruptcy?
Not necessarily. The bankruptcy statute permits the debtor to exempt certain personal belongings from liquidation, according to the type of asset and its value. Clothing, jewelry, home furnishings, an automobile and equity in a home can be protected in bankruptcy, depending on the value of the items. With a few exceptions, property encumbered by liens can be retained either by "reaffirming" the debt, meaning that the debtor agrees to repay the creditor regardless of the bankruptcy relief, or by listing the debt in a Chapter 13 repayment plan. Additionally, some liens or mortgages against property can be reduced or eliminated completely if the amount of the lien exceeds the value of the property.
How will bankruptcy affect my credit?
As a rule, bankruptcy relief will affect your credit no worse than multiple defaults on loans, credit cards and other debts would. In reality, the person seeking bankruptcy relief already suffers from damaged credit, and a bankruptcy can do no more damage.
In fact, many, if not most, of my clients have reported that their credit scores have gone up after receiving a bankruptcy discharge. The increase has been anywhere from 25 to 150 points.
The advantage to debt discharge through bankruptcy is that once relief is granted, past creditors can no longer seek repayment of the debts through hounding collection efforts, lawsuits, etc. You also become a better credit risk because you cannot file for bankruptcy for another eight years.The "fresh start" allows the debtor to rebuilt his or her credit slowly without carrying the burden of past debt.