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Types of Bankruptcy and How It Works? A Complete Guide

Bankruptcy

Are you curious about what is bankruptcy? If yes, you came to the right place. In this blog, we will discuss what does bankrupt mean and the different types of bankruptcies you can file if you are in an economic slump. 

Imagine you are sitting on the couch staring at the pile of bills and wondering how you are going to manage without a paycheck. Or you could have recently lost your job and trying to figure out how to make ends meet. In this scenario, bankruptcy is a viable option. However, bankruptcy is not an option to take lightly. It is important to learn exactly what bankruptcy means and what the different types of bankruptcies are to make an informed decision. 

Bankruptcy may provide relief from your debts however it negatively impacts your credit score. Filing for bankruptcy stays on your credit report for 7 to 10 years and also affects your ability to get loans at favorable rates and open credit card accounts. The United States Bankruptcy Code offers six different types of bankruptcy. These are Chapter 7, Chapter 9, Chapter 11, Chapter 12, Chapter 13, and Chapter 15. 

Keep reading more to learn more about bankruptcy and the consequences of bankruptcy along with its pros and cons. 

What is Bankruptcy?

Unlike in Monopoly, bankruptcy in real life is a serious issue. It means going before a judge and telling them you are unable to pay your debts. In this case, the judge either discards your debts or arranges for a plan to help you pay them. 

There are several reasons why a person files for bankruptcy- losing a job, divorce, medical emergency, and death in the family are some of the most common reasons. Moreover, in 2018, over 730,000 non-business bankruptcies were filed. 

In layman’s terms, bankruptcy is a legal proceeding that is initiated when a person or business is unable to pay outstanding liabilities and bad debts. While it is a very serious issue and hampers your credit score for years, it also offers a brand new start for people who are unable to pay their bills any longer. 

The bankruptcy process starts with filing a petition by the debtor or on behalf of the creditors. If a person or business files for bankruptcy, all of their assets are evaluated and may be used to pay a portion of the outstanding debt. 

Note: The most common types of bankruptcies include Chapters 7 and 13. Both of these options are available to a wide range of the public, although you must meet the given requirements to file for a Chapter 7 bankruptcy. Chapter 11 is also a common form of bankruptcy and is sought by both businesses and individuals. 

Few bankruptcies are filed under Chapters 9,12, and 15 as these are primarily intended for municipalities, family-owned farms or fishing operations, and entities in multiple countries respectively. 

Bankruptcy Process: An Overview

  • The bankruptcy process starts with filing a petition at your local federal bankruptcy court. 
  • The petitioner is required to submit various forms and in-depth information about their financial condition including tax returns, income documents, mortgage statements, and bank statements. 
  • The petitioner must also take a pre-bankruptcy credit counseling course and a pre-discharge debtor education course from approved providers. 
  • After filing the petition, the filer meets with a court-appointed trustee in a 341 meeting to answer questions about the petitioner’s ability to repay debts. 
  • After a period of several months to years depending on your type of bankruptcy, the discharge is issued.

While the benefits of bankruptcy include blocking creditors from collecting more debts, its negative impacts can persist for much longer. It stays on your credit report for years to a decade. 

Although most of the process depends on the chapter of bankruptcy, this is the basic bankruptcy process. It is important to examine your options to make an informed choice and pick the right chapter. 

Now, let’s discuss the various types of bankruptcies to help you choose the best one. 

Read Also:- Does Bankruptcy Clear Bank Debts?

Different Types of Bankruptcies

Filing for bankruptcy in the United States is dependent on the type of bankruptcy code that applies. As mentioned above, Chapters 7 and 13 are the most common types of bankruptcy cases. For instance, Chapter 7 involves the liquidation of your assets and Chapter 13 involves arranging for debt repayments. Here are the most common bankruptcy types that you can file. 

Chapter 7

Chapter 7 is among the most common types of bankruptcy. It allows the petitioner to get rid of unsecured debts like medical balances and outstanding credit card balances. 

In Chapter 7 bankruptcy, you must liquidate your assets to repay all or some of your outstanding debts if you have assets like ancestral property, family heirlooms, stamp collections, second home, or stock investments. 

In layman’s terms, you sell off your assets to pay off your debts in Chapter 7 bankruptcy However, people who have no valuable assets like vehicles, property, and household goods, may not repay any part of their unsecured debt. 

Chapter 11 Bankruptcy

Chapter 11 bankruptcy is often filed with the objective of reorganizing and still remaining in business. Filing for Chapter 11 allows a company to create fresh plans to increase profitability, increase revenue while finding new ways to cut corners. The preferred stockholders of the company still receive payments. 

For example- if you have a housekeeping business, you can file for Chapter 11 bankruptcy and still stay in business by increasing your rates and offering additional services to remain profitable. The business is allowed to stay in business while working on a debt repayment plan supervised by the court. In some rare cases, individuals can also file for Chapter 11 bankruptcy. 

Read Also:- Navigating Various Types of Debts for Your Financial Freedom

Chapter 13 Bankruptcy

Chapter 13 bankruptcy also known as the wage earner’s plan is specifically for individuals who earn too much to qualify for Chapter 7. It enables individuals and businesses with a consistent cash flow to create reliable repayment plans for their debts. 

Most repayment plans leverage monthly installments over a period of three to five years. In exchange for repaying their creditors in full, the court allows the individuals or businesses to stay in business and keep all of their properties. 

Other Bankruptcy Fillings

While Chapters 7, 11, and 13 are the most commonly filed bankruptcy cases, there are several other types that are less common but worth looking at- 

  • Chapter 9 Bankruptcy- It is primarily available to municipalities such as cities, towns, villages, school districts, and counties. In Chapter 9, municipalities are not required to liquidate their assets to repay their debts but are allowed to develop a plan to repay the debts over time. 
  • Chapter 10 Bankruptcy- This type of bankruptcy was officially suspended in 1978 and supplanted by Chapter 11. 
  • Chapter 12 Bankruptcy- It mainly caters to family farms and fishing businesses. Chapter 12 allows them to keep their assets and formulate a plan to repay their debts over time. 
  • Chapter 15 Bankruptcy- It was introduced in the law in 2005 and mainly caters to cross-border cases which mainly include debtors, assets, creditors, and other concerned parties that are operating in more than one country. This type of bankruptcy is usually filed in the debtor’s home country. 
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How to Select a Bankruptcy Type?

Are you trying to file for bankruptcy and struggling to determine which type should you file into? Choosing a chapter to file into is ultimately up to the debtor. 

Typically, Chapter 7 is best for those that want to sort things out as soon as possible and have limited income and few assets. However, filing under Chapter 7 requires passing a means test. Moreover, if your earnings are high, the court will deny a Chapter 7 petition or switch it to a Chapter 13 bankruptcy. 

However, Chapter 13 is particularly best for those that want to retain their possessions and have the necessary cash flow to support repayment. 

Chapter 11 is best for businesses whose objective is to stay in business while working on formulating a debt repayment plan. 

Many petitioners are represented by bankruptcy attorneys who guide them to make informed decisions. If you are looking for a competent bankruptcy attorney, you can consult your close relatives and friends. You can also consult professional organizations like the National Bar Association to find referrals to reliable lawyers. 

Debts That Aren’t Absolved

While bankruptcy is used to eliminate a wide range of bad debts, there are certain unforgivable debts that still remain. These include- 

  • Student Loan Debts
  • Court-ordered Alimony
  • Reaffirmed Debt
  • Tax Owed to the U.S Government
  • Government Fines and Penalties
  • Court Fines and Penalties

Advantages and Disadvantages of Bankruptcy

You can relieve a lot of your legal obligations by filing for bankruptcy. However, it will also significantly lower your credit score, making it hard to get loans, mortgages, and credit cards. If you are already thinking about bankruptcy, chances are your credit score is already low. But it’s worth noting that a Chapter 7 bankruptcy will stay in your credit history for 7 to 10 years. 

ProsCons
Allow debtors to emerge from defaultHampers your credit score
Eliminates certain unsecured debtsSecured debts seize the collateral
Avoids legal judgment. Debts like child support are not eligible for discharge. 

Read Also:- 5 Major Factors That Affect Your Credit Score

What Are Some Alternatives to Avoid Bankruptcy?

No matter how much debt you have, it is possible to avoid bankruptcy. For that, it is essential to know the alternatives to bankruptcy so you don’t have to damage your credit score for years. 

Take Care of Necessities

Before you start lavishly spending your income, you must take care of the basic necessities which are food, shelter, utilities, and transportation. You won’t be able to fight out of debt if you don’t have a roof over your head or food to eat. First and foremost, make sure to feed your family and take care of the basic necessities before paying the collectors. 

Formulate a Budget Plan

More often than not, extravagant spending without a reliable income source is the reason for bankruptcy. Moreover, when you file for bankruptcy, the court tracks your spending and puts you on a supervised budget. If you’re drawing your last straw, formulating a strict budget plan and sticking to it may be your best option. If you properly track your expenses and cash flow, you will find the money you didn’t even realize you had. 

It goes without saying that you have to cut off all unnecessary expenses. Say goodbye to streaming subscriptions, no more dining out, and no more vacations. Closely monitor all your expenses and cut costs where possible. With enough persistence, you can get out of your economic slump without involving the authorities. 

Boost Your Income

Your income is one of the most powerful tools in the fight against bankruptcy. The more revenue you generate, the more debts you can clear. You can start by working double shifts or picking up a side hustle to augment your income and clear monthly payments and bills. It will be an exhausting venture, but it is an insignificant sacrifice in the long run. 

Sell Your Valuables

As mentioned above, the court liquidates your assets in Chapter 7 bankruptcy. But what if you sell your valuables without involving the court? If you have valuables like yachts, fancy cars, and appliances that you don’t use, sell them as soon as possible! Sounds a little extreme but this is exactly what will happen if you file for bankruptcy, except you will not even have control over which assets to sell. You can use various online platforms like eBay, Facebook Marketplace, and Craigslist to sell your assets for some quick cash. 

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Key Takeaways

  • Bankruptcy is a legal proceeding that absolves the petitioner of any debts that they may have. 
  • Creditors still have an opportunity for repayment with the bankruptcy process.
  • Mostly, the bankruptcy process is handled by federal courts by following the U.S. Bankruptcy Code. 
  • If you file your bankruptcy, your assets will be liquidated and used to repay your creditors. 
  • A bankruptcy will reflect on your credit report for 7 to 10 years making it difficult to get loans and credit cards. 
  • There are primarily 7 types of bankruptcy. However, Chapter 7 and Chapter 13 are the most common types of bankruptcy filed in courts. 
  • Choosing the type of bankruptcy ultimately depends on the debtor. It will depend on your goals and current financial condition. 
  • While filing for bankruptcy can eliminate several debts, there are certain unforgivable debts like student loan debts, court-ordered alimony, court fines, and penalties, etc. 
  • Some alternatives to avoid bankruptcy include formulating a budget plan, boosting your income, and selling your valuables. 

Frequently Asked Questions(FAQs)

Q.1 How does one file for bankruptcy?

Ans. Bankruptcy is a legal proceeding that begins with the debtor filing a petition with a federal bankruptcy court. This can be done by contacting a reliable attorney that specializes in these types of cases.

Q.2 What are the disadvantages of filing for bankruptcy?

Ans. The downside of filing for bankruptcy includes a huge negative impact on your credit score that lasts for a decade. As a result, it will be even harder for you to get loans, credit cards, and mortgages.

Q.3 What are the unforgivable debts that aren’t resolved with bankruptcy?

Ans. While bankruptcy provides relief to the petitioner by eliminating most existing bad debts, there are still various types of debts that are not resolved. These include- 

1. Alimony and Child Support
2. Certain unpaid taxes like tax liens
3. Debts for willful and malicious injury to a property or another person. In Chapter 13, this only applies to injury to another person. Debts of property damage are resolved in Chapter 13. 
4. Debts for death or injury caused by the debtor’s vehicle. 
5. Debts that you didn’t list in your bankruptcy filings
6. Common maintenance fees for condo associations

Q.4 Is filing for bankruptcy a good choice?

Ans. For individuals or businesses that are under a surmountable amount of debt, bankruptcy may be a good option. If debts become too large, the only solution is the liquidation of assets and legal judgments for non-payment and breach of contract. However, it will damage your reputation and credit score, bankruptcy is a legal way to avoid going to jail and avoiding the worst-case scenario possible.