Bankruptcy is the legal process under federal law that allows a consumer to obtain a “fresh start” when they are overwhelmed by debt. Depending upon the type of bankruptcy filed by the consumer, debts are either canceled or reorganized. The process of bankruptcy also enables creditors to receive payment or collateral to pay off some or all of the debts owed to them by the consumer.
Bankruptcy often becomes an option for consumers who have fallen behind in their credit card payments, mortgage payments or other credit obligations. However, bankruptcy does not eliminate all types of debt. For example, debts assessed by judgments of fraud and other government fines cannot be discharged in a bankruptcy filing. Child support and alimony also may not be included. Student loans and certain taxes may not be included in the filing as well.
Once a consumer files for bankruptcy, an “automatic stay” immediately takes effect. The automatic stay requires creditors to stop collection, repossession and foreclosure proceedings against the consumer. However, the automatic stay is only a temporary measure to provide some immediate relief to the consumer until the bankruptcy is granted by the court.
Types of Personal Bankruptcy
United States Federal law provides for two main types of personal bankruptcy filings: Chapter 7 and Chapter 13. The major difference between the two types of filings is that with the Chapter 13, all or part of the debt is paid to creditors, whereas with Chapter 7, some debt is simply eliminated. However, with a Chapter 7 filing, the judge or trustee may order certain assets be sold or forfeited by the creditor. Property may be liquidated to pay creditors for the incurred debt. Typically, a Chapter 7 filing will be completed in four to six months.
With a Chapter 13 filing, the consumer helps develop a payment plan that is presented to the court for approval. The payment plan proposes to pay all or a portion of debt owed to creditors. Once the plan is approved by the court, the plan is usually executed over a three- or five-year period.
Chapter 7 is often referred to as a “liquidation filing.” In a Chapter 7 filing, the court liquidates assets that are not exempted by the state’s bankruptcy laws. Each state places exemptions on the consumer’s assets that may not be liquidated in a Chapter 7 filing. These exemptions vary widely from state to state, and may include equity in homes or cars. The federal government also specifies a set of exemptions. The debtor has the option of choosing whether to use their state’s set of exemptions or the federal government’s set of exemptions.
Chapter 7 filing is often recommended for individuals and couples with low incomes. Chapter 7 is also recommended for consumers who do not own real property. However, as long as the consumer is able to continue to making payments on their property, the court will generally allow them to retain ownership.
Chapter 13 is often referred to as a “debt restructuring.” This is because Chapter 13 is often the choice for consumers who have experienced unemployment or a bit of bad luck, but generally have the means to repay their creditors.
Chapter 13 may be an option for debtors who:
- Fell behind in their bills due to unemployment
- Face foreclosure or repossession due to a change in employment or family structure
- Own property but now face overwhelming credit card and other debt
- Have temporary changes in business that caused interruptions in the debtor’s income
The Chapter 13 bankruptcy allows the debtor to restructure their debt in such a way that they may be able to pay their creditors and keep their home, vehicle and other property. The creditors are paid according to the Chapter 13 plan and the consumer gets some debt relief in the process.
On the negative side, both Chapter 7 and 13 filings stay on the consumer’s credit report for up to 10 years. A bankruptcy filing negatively affects FICO scores by as much as 200 points for a period of time. The FICO score typically drops dramatically after filing, but the debtor should be able to immediately start rebuilding their credit. Because a debtor’s FICO score may have already been adversely affected prior to filing bankruptcy, a FICO score decrease of 200 points may not impact the debtor in a major way. Bankruptcy is a way for the debtor to get out from under insurmountable debt and get a fresh financial start.