Bankruptcy: How It Works, Types and Consequences

How Does Bankruptcy Work?

Bankruptcy is a legal process designed to help consumers obtain relief from debt they can't afford to repay while also ensuring that creditors receive some payment based on the borrower's financial situation and assets.

Once you file for bankruptcy, your creditors must halt all collection attempts, including things like foreclosure, repossession and wage garnishment. That said, only certain types of debt can be included in bankruptcy—more on that in a minute.

Depending on which type of bankruptcy you choose—Chapter 7 or Chapter 13—you may need to repay a portion of what you owe based on your financial situation and assets. All remaining debt will be discharged, meaning you no longer have an obligation to pay it—and creditors can no longer attempt to collect.

Although you can technically file for bankruptcy on your own, it often makes sense to enlist the help of a bankruptcy attorney who can help you determine which type of bankruptcy is right for you, guide you through the process and act as your representative in the proceedings.

What Is Chapter 7 Bankruptcy?

Chapter 7 bankruptcy, also known as straight or liquidation bankruptcy, involves selling off some of your assets to pay off what you can and discharging the rest of your debts.

The court assigns a trustee to your case who will manage the liquidation of your assets and pay your creditors with the proceeds. Certain assets are exempt, but the types and amounts can vary by state.

From start to finish, the process typically takes between four and six months. Keep in mind, though, that not everyone qualifies for Chapter 7 bankruptcy. You'll need to pass a means test or meet certain criteria for low income, among other prerequisites.

What Is Chapter 13 Bankruptcy?

Also known as reorganization bankruptcy, Chapter 13 bankruptcy will restructure your debts in a way that allows you to pay off a portion of what you owe—or possibly all of it—over a period of three to five years.

You'll propose a monthly payment amount based on your financial situation, which your creditors can accept or object to—at which point, you may need to negotiate.

In exchange for a longer process, Chapter 13 bankruptcy allows you to keep your assets. There's also no means test requirement to take advantage of this option, and the length of your restructured repayment term will depend on your income level. However, you will need to complete certain other requirements before you file.

Key Bankruptcy Terms to Know

Throughout the bankruptcy process, you'll likely come across some legal terms that may not be familiar to you. Here are some of the most common and important ones to know:

• 341 meeting: Also known as the meeting of creditors, you'll be questioned under oath by your creditors or the trustee about your financial situation.
• Credit counseling: Before you can file for bankruptcy, you'll need to undergo individual or group credit counseling. You'll also be required to take a personal finance management course before your bankruptcy can be discharged. However, there are situations where one or both requirements can be waived.
• Discharge: When bankruptcy proceedings are complete, the bankruptcy is considered discharged. At this point, any remaining debt you haven't paid is canceled, and your creditors can no longer pursue payment.
• Exempt property: Although Chapter 7 bankruptcy requires you to sell assets to repay creditors, some types of property may be exempt from sale. State law determines what a debtor may be allowed to keep, but generally, items like work tools, a personal vehicle or equity in a primary residence may be exempted.
• Lien: A legal right for a creditor to hold and sell a debtor's property as security or repayment of a debt.
• Liquidation: The sale of a debtor's non-exempt property, the proceeds of which are then used to pay creditors listed in the bankruptcy.
• Means test: The Bankruptcy Code requires people who want to file Chapter 7 bankruptcy to demonstrate that they do not have the means to repay their debts. The requirement is intended to curtail abuse of the bankruptcy code. The test takes into account information such as income, assets, expenses and unsecured debt. If a debtor fails to pass the means test, their Chapter 7 bankruptcy may either be dismissed or converted into a Chapter 13 proceeding.
• Reaffirmation agreement: Under Chapter 7 bankruptcy, you may agree to continue paying a debt that could be discharged in the proceedings. Reaffirming the debt—and your commitment to pay it—is usually done to allow a debtor to keep a piece of collateral, such as a car, that would otherwise be seized as part of the bankruptcy proceedings.
• Secured debt: Debt backed by property, such as a home or vehicle, which acts as collateral. Creditors of secured debt have the right to seize the collateral if you default on the loan.
• Trustee: An individual or corporation appointed by the bankruptcy court to act on behalf of the creditors. A trustee is responsible for reviewing your petition and schedule and bringing action against you or your creditors to resolve the matter. Under Chapter 7 bankruptcy, the trustee will liquidate your non-exempt assets and distribute the proceeds to your creditors. In Chapter 13 filings, the trustee also oversees the debtor's repayment plan, receives payments from the debtor and disburses the money to creditors.
• Unsecured debt: A debt for which the creditor holds no tangible collateral, such as credit cards.

Debt That Can't Be Forgiven in Bankruptcy

While bankruptcy can eliminate a lot of debt, it can't wipe the slate completely clean if you have certain types of unforgivable debt. Types of debt that bankruptcy can't eliminate include:

• Court-ordered alimony
• Court-ordered child support
• Reaffirmed debt
• A federal tax lien for taxes owed to the U.S. government
• Government fines, penalties or benefit overpayments
• Court fines and penalties
• Debt for personal injury caused while intoxicated
• Debt for willful and malicious injuries to a person or property
• Debt owed to certain tax-advantaged retirement plans
• Debt for certain condominium or cooperative housing fees

Historically, it's been difficult—though not impossible—to discharge student loans in bankruptcy. However, changes made by the U.S. Department of Education in November 2022 have made the process much easier.

In the first 10 months of the new process, 632 bankruptcy cases were filed that included federal student loans, and 99% of them received full or partial discharges, according to the U.S. Department of Justice.

Consequences of Bankruptcy

If your financial situation is dire, bankruptcy may be the only way to get the relief you need. However, there are several consequences to consider before you proceed.

Loss of Property

With Chapter 7 bankruptcy, you'll be required to liquidate some of your assets to repay your creditors. Even with Chapter 13 bankruptcy, you may need to sell off certain assets to afford your payments.

If you include secured debt, such as a mortgage loan or auto loan, in your bankruptcy filing, you could also lose the property or vehicle you used as collateral for the debt.

Credit Damage

Your payment history is the most influential factor in your credit score, and filing for bankruptcy means you're unable to pay your debts in full. As a result, bankruptcy can have a drastic impact on your credit score.

What's more, a Chapter 7 bankruptcy can stay on your credit report for 10 years from the filing date—it's just seven years for Chapter 13. While a bankruptcy's negative impact can diminish over time, especially if you're vigilant about rebuilding your credit, it can still make it challenging to get approved for affordable credit options for several years after your filing has been discharged.

Impact on Others

If a loved one cosigned one of the loans you're including in your bankruptcy, they may be responsible for paying at least some of the debt.

Some Debt May Remain

As previously mentioned, not all debts are includable in a bankruptcy filing. While you may get some relief, you may not necessarily get a clean slate.

Pros and Cons of Bankruptcy

Although bankruptcy should only be considered as a last resort, it's not entirely a negative step. Before you file, it's important to consider both the advantages and disadvantages of bankruptcy and how they might impact your particular situation.

Pros

• It stops collection efforts. If you're fielding aggressive collection calls, you've been sued for payment or you're subject to wage garnishment, filing for bankruptcy will stop all of these activities.
• It can give you the relief you need. If you've exhausted all other alternatives, bankruptcy may be the only way to get the financial relief you're seeking. Depending on your situation, it could even give you a fresh financial start, albeit with some work ahead of you to rebuild credit.
• You can get a repayment plan that works for you. If you've been unsuccessful in negotiating a restructured repayment plan with your creditors, bankruptcy may help you get a plan that works for your budget.

Cons

• It can ruin your credit. Although bankruptcy can make sense for your overall financial well-being, it can take several years to rebuild your credit history. As a result, you may need to put certain financial moves on hold until you can qualify for better terms.
• You can lose some of your assets. Regardless of which type of bankruptcy you choose, you may need to sell off some of your assets to cover payments. That can include things like non-retirement investments, jewelry, furniture and more.
• It's not a guarantee. Depending on your financial situation, there's no guarantee that you'll qualify for bankruptcy. Even if you do, you may not get the results you're looking for.

Getting a Credit Card or Loan after Bankruptcy

After your bankruptcy has been discharged, you're free to apply for credit again. But having the public record on your credit reports will make it difficult for you to get approved for most loans and credit cards.

That doesn't mean you'll have no options at all. But among the options that are available, you may be faced with high interest rates and fees, at least until you've spent time rebuilding your credit.

Getting a Mortgage After Bankruptcy

While there are some forms of credit available shortly after bankruptcy, you'll typically have to wait a while before you can get approved for a mortgage loan.

That's because most home loan programs have a waiting period, which can be anywhere from one to four years from the date of your discharge. The period is typically longer if you filed for Chapter 7 bankruptcy.

Even after you complete the waiting period, you'll still need to meet all the other requirements to get approved, and you still may end up with a higher interest rate.

If you're thinking about including a mortgage loan in your bankruptcy, consider whether it makes more sense to reaffirm your mortgage during bankruptcy proceedings. You would be able to keep your home, continue paying on your current mortgage—free of other debts—and stay in your current home.

How to Rebuild Your Credit After Bankruptcy

You'll have a hard time getting approved for credit while your bankruptcy is still open. Once your case has been discharged, the rebuilding process can take several years, so it's a good idea to get started as quickly as possible. Here are some steps you can take:

• Apply for a secured credit card. Secured credit cards can help you establish a positive payment history as you use your card responsibly and pay your bill on time every month. Keep in mind, though, that you'll typically need to make a security deposit equal to your desired credit limit to get approved.
• Get a credit-builder loan. You may consider a credit-builder loan in addition to or instead of a secured credit card. With this installment loan, the lender will hold the loan proceeds—usually between $300 and $1,000—in a separate account while you make payments, which the lender will report to the credit bureaus. Once you've completed your repayment term, which can range from six to 24 months, you'll receive the loan funds.
• Become an authorized user. If you have a loved one who uses their credit card responsibly, consider asking them to add you as an authorized user on the account. Once you have authorized-user status, the account's full history will show up on your credit reports, which can help improve your credit score. Just be sure to confirm that the primary cardholder always pays on time and maintains a low balance relative to their credit limit. Otherwise, being an authorized user may not do much good.
• Get a cosigner. If you need a loan to buy a car or finance another large purchase, you may consider asking a loved one with great credit to cosign the loan application. Their creditworthiness can help improve your chances of securing favorable terms, and your on-time payments can contribute to a positive credit history.

Alternatives to Bankruptcy

When you're struggling with unmanageable debt, bankruptcy is just one possible solution. Some of the alternatives may also negatively impact your credit, but usually not as drastically as filing for bankruptcy. Here are just a few options to consider.

Debt Consolidation

If your credit is still in good shape, and you can likely afford to repay your debt with a less demanding repayment plan, research debt consolidation loans and balance transfer credit cards to see if consolidating your debt can make the payments more manageable.

With that in mind, consolidation may not work for you if your credit is in fair or poor shape.

Debt Management Plan

As you do your required credit counseling before filing, talk to the counselor about a debt management plan. With this option, the counselor can work with your creditors to help arrange a workable plan for repaying what you owe, which can include lower interest rates and monthly payments.

Debt management plans typically last three to five years and come with modest upfront and monthly fees. However, it only works for unsecured debt like credit cards, medical bills and personal loans.

Forbearance or Deferment

If your financial challenges are short-term in nature, consider asking some of your creditors about forbearance or deferment. These options typically involve pausing your monthly payments for a short period—usually just a few months—giving you some time to get back on your financial feet.

That said, the process can vary by lender and loan type, so make sure you understand the terms before you agree.

Debt Restructuring

Depending on the type of loan you have, you may be able to negotiate a restructuring of your debt. Debt restructuring can come in the form of a temporary or permanent adjustment to your loan agreement, or even a settlement for less than what you owe.

Before you pursue any of these options, however, do a free consultation with a credit counselor to get expert advice for your situation.

The Bottom Line

Before you make any decision about bankruptcy or any other form of debt relief, it's important to research your options, get reliable advice from a qualified credit counselor and understand the impact your choices can have on your overall financial well-being.

Regardless of what type of debt relief you choose, be proactive about improving your credit score now and in the future to help minimize the negative consequences of certain relief options.

Additionally, consider registering for Experian's free credit monitoring service, which provides access to your FICO^® Score^☉ and Experian credit report, along with real-time alerts when changes are made to your report. With this information, you'll have a better handle on how your actions impact your credit and which steps you can take. You'll also be able to track your progress throughout the rebuilding process.