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What is bankruptcy?

Events like a job loss, hospitalization, extended illnesses or divorce sometimes make it difficult to pay bills on time. Bankruptcy is a legal process through which people and businesses eliminate or repay debts under the protection of U.S. bankruptcy court.

Filing bankruptcy is a complex process with many rules that specify the types of debts covered, exceptions, requirements for filing and what property petitioners can and cannot keep.

Knowing bankruptcy basics helps people choose the best option for their situations.

3 types of bankruptcy

In the U.S., there are several bankruptcy options available to individuals and businesses, but the most commonly used types are Chapter 7 and Chapter 13 bankruptcies.

Chapter 7 bankruptcy is a liquidation option, while Chapter 13 bankruptcy is essentially a repayment plan. For those who qualify, understanding the differences between the two choices helps people select the best option for their situations.

Chapter 7

When consumers or businesses file Chapter 7 bankruptcy, they liquidate their assets to pay all or part of the outstanding debts.

Most state and federal laws let them keep their personal property, including clothes and household furnishings as well as property the trustee doesn’t want to take. In some cases, they can keep the cars they own.

Creditors sell secured items such as property and cars and apply the proceeds from the sale to the debt.

Under this type of bankruptcy, the court eliminates most unsecured debt, including credit cards and medical bills.

For this reason, the requirements for Chapter 7 are more stringent than Chapter 13, as the court wants to make sure the debtors do not have available assets to pay the bills.

Petitioners must prove that there are no other income sources available and that their disposable income is not sufficient enough to cover a repayment plan allowed under Chapter 13 bankruptcy.

Chapter 13

Chapter 13 bankruptcy is an option for people who have a reliable source of income and the ability to pay back their debts.

Under Chapter 13, the petitioners go through court-mandated credit counseling and create a detailed plan that shows how they will repay their debtors within 3 to 5 years.

Petitioners get to keep all their property and enjoy protection from repossession or foreclosure.

To create a Chapter 13 repayment plan, the petitioner and trustees evaluate the amount of the debts, calculate the amount of money unsecured creditors would have received under a Chapter 7 bankruptcy and prioritize them.

Certain debts like tax bills and child support go to the top of the list, where they receive first, and complete, payments.

The repayment plan also needs to show all available sources of income and identifies how disposable income will be applied to pay the debts owed.

Chapter 11

A third form of bankruptcy, under Chapter 11 of the bankruptcy code, also is available to consumers and businesses.

This type of bankruptcy offers protection to petitioners who want to reorganize their financial affairs. The process is time-consuming and expensive, so few consumers take advantage of this option and only do so if their debts exceed the allowed amounts for Chapter 13 bankruptcy.

Effects of bankruptcy

Bankruptcy has positive and negative effects on the people who choose to file. It stops creditors from taking action to collect money owed to them. It prevents or delays repossessions or foreclosures. It also stops wage garnishments, providing relief to those struggling with excessive amounts of debt.

Bankruptcy also carries negative financial consequences that affect the petitioners for years. A Chapter 7 bankruptcy appears on credit reports for 10 years, and a Chapter 13 bankruptcy stays for seven years.

During this time, creditors may not approve loans, insurance premiums may rise and landlords may refuse rental applications. The bankruptcy also lowers credit scores, but most people who file for bankruptcy do so after their credit scores already have been damaged.

Alternatives to bankruptcy

For many people, bankruptcy is the final solution for gaining control over debt, and it is not a perfect solution for everyone.

Some debts, like child or spousal support, tax debt, and student loan do not qualify for discharge in bankruptcy, so individuals with substantial amounts of those debts may not see much relief.

Alternatives to bankruptcy include debt negotiation and consolidation, which involve making an agreement with creditors to lower the balance owed or combining all debts into a single payment.

Could a home equity loan help you avoid bankruptcy? Compare home equity rates.

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