What Does Filing Bankruptcy Do?

The process of filing for bankruptcy can be a powerful tool if you’re hoping to get out of debt. Bankruptcy can erase credit card debt, medical bills, other types of unsecured debt, and can stop wage garnishments and other collection actions. The two most common types of consumer bankruptcy individuals and married couples file are Chapter 7 and Chapter 13 bankruptcies. In this article, we’ll explore both types of bankruptcy cases and how they can give families a financial fresh start. 

Filing Bankruptcy Immediately Stops All Debt Collection Activities

As soon as you file a bankruptcy case, all debt collection activities against you must stop. This is the power of the automatic stay, which protects filers from creditor actions while their bankruptcy case is pending. This safeguard offers immediate stress relief to people who feel like they’re drowning in debt. Putting an end to collection phone calls and constant demands for payment can be a huge burden lifted from your shoulders. Contrary to popular beliefs, filing for bankruptcy does not spell financial ruin – filing for bankruptcy can actually be what gives you the breathing room to manage your financial situation and get you back on your feet. 

When you file for bankruptcy protection and the automatic stay takes effect, creditors can no longer call you, garnish your wages, repossess your vehicle or other personal property, levy your bank account, foreclose on your house, send collection letters, or advance any lawsuits for unpaid debts.  However, the power of the automatic stay isn’t forever. A creditor can ask the court to lift the stay, which is essentially asking the bankruptcy court for permission to continue collection action, such as a car repossession or a house foreclosure. 

Thankfully, even if the stay is lifted for a specific action, the automatic stay will remain in effect for other types of collection activities until the end of your bankruptcy case. At the end of a successful bankruptcy case, you’ll receive a bankruptcy discharge, which is a court order that says you no longer owe certain debt. Creditors of these debts can never legally attempt to collect from you again – which is why you don’t need the automatic stay to extend longer than your bankruptcy case. 

Bankruptcy Can Help Manage Your Debts

Bankruptcy gives people room to manage their debts and to take control of their financial situation. Of course, a bankruptcy filing isn’t the best solution for everyone. If you have debt problems, it’s a good idea to explore all of your debt relief options before committing to a plan of action.

The process of bankruptcy proceeds differently depending on which chapter you file under. Chapter 7 and Chapter 13 are common for individuals but treat debt management differently. Bankruptcy laws create different categories of debts and offer relief based on those categories. Often, because only individuals who don’t earn much income are eligible to file for Chapter 7 bankruptcy, these cases can be “no asset” cases, meaning there’s nothing for the bankruptcy trustee to take and sell for the benefit of creditors. Usually, most of an individual’s creditors are paid (in part or, sometimes, in full) in Chapter 13 bankruptcy cases because this process sets up a 3 to 5-year repayment plan. 

Different types of debt are treated differently in bankruptcy. Priority debts are debts that are paid first in a bankruptcy. Priority debts include domestic support obligations, like spousal support (alimony) and child support. These types of debts are nondischargeable and cannot be erased by bankruptcy. Priority debts are paid in full in Chapter 13 cases. Secured debts are debts that are backed by collateral, like a house or a car. Bankruptcy can erase your personal liability to pay back the debt, but it won’t erase the lien attached to the property. If you want to keep a house or car with a mortgage or car loan, then you have to pay the debt off. Nonpriority debts are unsecured debts that are last in line for payment in a bankruptcy case. Nonpriority unsecured debts include credit card debt, medical debt, personal loans, utility bills, court judgments, back rent, among other types of debt. 

Generally, nonpriority unsecured debts owed at the end of bankruptcy are discharged. However, there are exceptions to this general discharge rule to be aware of. Student loans are considered nonpriority unsecured debt, but they are generally not discharged through bankruptcy. This means that student loans must be paid back even after a successful bankruptcy filing. Getting student loans discharged requires the filing of an adversary proceeding and a showing of undue hardship, which is an incredibly high burden to meet. 

Depending on the types of debts you have, bankruptcy can set you up with a clean financial slate and, as part of your credit counseling requirements, give you some tools to create a better financial future after your case is complete. 

What Does Filing Chapter 7 Bankruptcy Do?

Chapter 7 bankruptcy is the most common type of bankruptcy people file. It is the “liquidation” form of bankruptcy that provides for the sale of a debtor’s property to pay creditors. However, in more than 90 percent of cases, the filer is able to keep all of their belongings. Property and personal belongings valued up to a certain amount are generally protected through bankruptcy by exemptions. Exemption schemes that vary by state, although some states allow their residents to use the federal bankruptcy exemptions. Exempt property includes a certain amount of equity in real estate (the house you live in), cars, and other personal property, as well as retirement accounts and certain types of income and benefits, like Social Security. 

Not only can you keep most or all of your belongings despite filing for bankruptcy, but Chapter 7 can also discharge your nonpriority unsecured debts. After receiving a successful Chapter 7 discharge, you will no longer owe credit card debt, medical bills, or other eligible debts. Creditors of discharged debts can never legally attempt to collect those debts from you again. This can give you breathing room to get your financial affairs back in order so that you can pay your other, nondischargeable debts and move on with your life. 

Once your Chapter 7 bankruptcy petition has been filed, it will likely take approximately 3-4 months to receive your bankruptcy discharge. The discharge is the federal court order that relieves your obligation to pay back your eligible debts and prohibits those creditors from ever trying to collect on those debts again.  

The means test determines whether you’re eligible for relief under Chapter 7 of the Bankruptcy Code based primarily on your monthly income. If your income is below the state median for your household size, then you’ll automatically pass this test. If your income is above the state median for your household size, you may benefit from speaking with an attorney about whether you could still qualify for this form of bankruptcy protection by claiming more exemptions, etc. If you ultimately don’t qualify for Chapter 7 bankruptcy, you may qualify for relief under Chapter 13 of the Bankruptcy Code.

What Does Filing Chapter 13 Bankruptcy Do?

Chapter 13 bankruptcy creates a repayment plan that lasts 3 to 5 years. The bankruptcy trustee assigned to your case will collect your plan payments and then distribute the funds, in order of priority and in a pro-rata share, to your creditors with allowed claims. Depending on the specifics of your Chapter 13 bankruptcy plan, you may pay back most or all of your debt, or you may pay only a small percentage of your nonpriority unsecured debts. Every case is unique and the way this process will progress shall depend heavily on your income. Note that if your Chapter 13 case is dismissed before you make all of your plan payments, it can leave you in a worse financial situation than before you filed bankruptcy. 

Your monthly plan payment is calculated by subtracting your allowable monthly expenses from your income. The amount left over is considered your disposable income and will generally represent your plan payment. You’ll be responsible for making that monthly payment to the Chapter 13 bankruptcy trustee for the life of the plan, which will be 3 to 5 years depending on your income. Generally speaking, if your income falls below the state median for your household size, then your Chapter 13 plan will be for 3 years. If your income falls above the state median for your household size, then your Chapter 13 plan will last for 5 years. 

To be eligible for Chapter 13 bankruptcy, you must have regular monthly income so that you’re able to make your plan payments and your debt must be below the allowed limits. Chapter 13 debt limits are subject to change. Currently, a Chapter 13 filer must have unsecured debts less than $419,275 and secured debts less than $1,257,850. [1]

What Doesn’t Filing Bankruptcy Do?

Bankruptcy is a powerful legal tool, but it is not a miracle, cure-all pill. The fact is that filing for bankruptcy probably won’t be able to solve every financial problem you’re facing. It’s important to understand which of your debts bankruptcy can erase and which of your debts can’t be taken care of by filing for bankruptcy. Further, it’s important to understand the limits and drawbacks of filing Chapter 7 or Chapter 13 bankruptcy. 

Not all debts can be discharged through bankruptcy. Nondischargeable debts include domestic support obligations (alimony and child support), newer tax debts, certain fines and penalties owed to government agencies, criminal restitution and court fines, personal injury debts arising out of driving under the influence, debts incurred by fraud, (generally) student loans, and other debts specifically listed in the United States Bankruptcy Code as nondischargeable. 

Bankruptcy has other limits, too. Bankruptcy might not be able to save your house from foreclosure or your car from repossession. A Chapter 13 bankruptcy filing creates an opportunity for you to catch up on mortgage arrears or missed car payments. During your Chapter 13 case, you’ll have to make the monthly plan payment as well as stay current on your mortgage or car payments as they become due. It isn’t uncommon for Chapter 13 plans to fail because filers can’t keep up with their monthly payments to the trustee. Chapter 7 bankruptcy creates no such opportunity to catch up on missed mortgage or car payments. Although bankruptcy may not help you save your house or car, it can prevent the bank or loan company from seeking a deficiency judgment against you for the amount owed that sale of the property didn’t cover. 

Filing bankruptcy also doesn’t prevent you from making financial mistakes in the future. After receiving a discharge in a Chapter 7 case, you’ll have to wait 8 years before filing for Chapter 7 again. So it’s important to take the clean slate it gives you seriously. 

Finally, bankruptcy can’t fix your credit overnight. Credit repair takes time, but people who file bankruptcy do see an increase in their credit score over the several months after filing and are likely to have a higher credit score one-year post-bankruptcy than when they filed. This is because delinquent accounts of dischargeable debts will have a balance of zero, making your debt to income ratio more favorable. In some ways, it looks better on your credit report to get a handle on your debt by filing for bankruptcy than doing nothing to address the problem. 

Conclusion

Bankruptcy isn’t a cure-all for every debt problem, but filing for bankruptcy can be a good option for debt management and financial relief. If you’re interested in exploring if bankruptcy is the right option for you, Upsolve offers a free tool that helps people file bankruptcy on their own. If you don’t qualify to use the free tool or your case is complex, you can get a free bankruptcy evaluation from a private bankruptcy attorney.