How does bankruptcy work and what are the different types?

Food, utilities, gasoline, and housing—everything is a little more expensive these days. By the time you pay for necessities, it's tough to put aside money for emergencies.

If bills are piling up and your phone has been ringing off the hook with calls from collection agencies, take a deep breath. You don't have to change your number or disappear into the night. Depending on the situation, bankruptcy can actually help some people get back on their feet.

Keep reading to find out what bankruptcy is, how it works, and how it can affect your financial situation.

What is bankruptcy, anyway?

So, what is bankruptcy? It's a legal process that gives you a fresh start when you can't meet your financial obligations. Since it's enshrined in federal law, it's a completely legit way to get a handle on your finances, despite its perception as a largely negative undertaking.

Common types of bankruptcy

Chapter 7

Chapter 7, also known as a straight bankruptcy or liquidation bankruptcy, is the most common. It's designed for people and companies with limited financial resources. If you're interested in filing a Chapter 7 bankruptcy, you'll have to go through a means test to determine if your income falls below the limit.

If your income is over the limit, don't panic. Chapter 7 isn't the only type of bankruptcy. If you don't pass the means test, you may qualify for Chapter 13 bankruptcy instead.

The reason Chapter 7 is known as liquidation bankruptcy is because a trustee liquidates (or sells) some of their assets and uses the money to repay their creditors. Federal bankruptcy law allows you to exempt some of your assets from the liquidation process. Therefore, there's no need to worry that you'll end up living in an empty house with nothing but your thoughts to keep you company.

Chapter 11

Chapter 11 bankruptcy gives struggling businesses a chance to get their finances under control. Instead of closing its doors or selling its assets to pay off outstanding debts, a company that files for Chapter 11 bankruptcy comes up with a reorganization plan and submits it to the court.

Chapter 13

Chapter 13 bankruptcy is designed for consumers who earn too much income to qualify for a liquidation bankruptcy. This type of bankruptcy provides a chance to propose a repayment plan to the court. If the plan is approved, you'll have 3 to 5 years to repay your debts.

To file for Chapter 13 bankruptcy, you can't have secured and unsecured debts totaling $2,750,000 or more. Fortunately, most individual filers meet this requirement. 

Secured debts are backed by collateral, or assets you must forfeit if you don't repay a debt as agreed. For example, if you don't pay your mortgage, the bank can foreclose, sell the home, and use the proceeds to cover some or all of your balance. In this case, the home is the collateral used to secure the loan.

Unsecured debts aren't backed by collateral. If you don't pay an unsecured debt, the lender can take you to court, but they can't seize your property and sell it. A traditional credit card is a good example of an unsecured debt.

How does bankruptcy work?

Since bankruptcy is a legal process, there are specific steps you must follow to make sure your case goes off without a hitch. These include filing your petition, completing the bankruptcy schedules and statements, and attending a meeting of your creditors.

What does filing for bankruptcy mean?

If you decide that bankruptcy is a good option, you'll need to file a petition with the court. The petition asks for detailed information about your financial situation, such as how much debt you have and how many creditors you owe.

Within 14 days of filing your petition, you'll have to submit your bankruptcy schedules and other documents to give the court more information about your finances. The following schedules are required for both Chapter 7 and Chapter 13 cases:

• Schedule A/B (Property): You must tell the court about all the property you own, including real estate, jewelry, clothing, vehicles, and home furnishings. Even if all you own is a mattress and a couple of pillows—you must list them on Schedule A/B.

• Schedule C (The Property You Claim as Exempt): Exemptions allow you to keep some or all of your property. Schedule C is where you document each exemption for the court. 

• Schedule D (Creditors Who Have Claims Secured by Property): Schedule D is where you list your secured debts, such as an auto loan or a mortgage.

• Schedule E/F (Creditors Who Have Unsecured Claims): On Schedule E/F, you list every unsecured debt you have, such as credit cards, student loans, personal loans, and medical bills.

• Schedule G (Executory Contracts and Unexpired Leases): An executory contract is simply a contract that hasn't been fulfilled. For example, you may have a 2-year equipment lease that you haven't finished paying on. Unexpired leases are exactly what they sound like—a lease for an apartment, rental home, or commercial property that hasn't ended yet.

• Schedule H (Your Codebtors): A codebtor is a person who shares the responsibility for one of your debts. If your mother cosigned on your car loan, for example, she's a codebtor for the purposes of filling out Schedule H.

• Schedule I (Your Income): You need to tell the court about every source of income you have. This includes earned income from a job, interest from bank accounts, and dividends from your investment accounts.

• Schedule J (Your Expenses): The court also needs to know how much money you spend each month. Don't forget to include streaming subscriptions, newspapers, magazines, as all those little purchases that tend to add up.

In addition to these schedules, you'll need to provide financial statements and other information about your situation. Pay close attention as you fill out each form, as the court can deny your case if anything is missing or incorrect.

Bankruptcy exemptions

As explained earlier, exemptions let you protect some or all of your property if you have to file for bankruptcy. In a Chapter 7 filing, exemptions prevent the bankruptcy trustee from taking property and selling it. If you file for Chapter 13 bankruptcy, exemptions reduce the amount of money you have to pay your creditors as part of your repayment plan.

Each state has its own set of bankruptcy exemptions. As of 2023, three-fifths of them require you to use the state exemptions, but there are 20 states that allow you to pick between the state and federal lists.

Unfortunately, you can't mix and match federal and state exemptions. You have to pick one set and stick with it. That means you need to review the exemptions carefully and decide which set is most advantageous to your case.

For instance, if you're worried about losing your vehicle in a Chapter 7 bankruptcy, you might want to use the set of exemptions that gives you the most protection. As an example, let's say you have a used car worth $4,500.

Under the federal set, you can only exempt $4,450 worth of equity in a vehicle. If you live in a state that allows you to exempt $5,000 or more, you may want to use the state exemptions so your vehicle isn't at risk.

Exemptions may help you protect your vehicle, the money in your checking or savings account, heirloom jewelry, tools, lawn equipment, and other property.

The meeting of the creditors

Regardless of whether you file for Chapter 7 or Chapter 13 bankruptcy, you'll have to attend a meeting of the creditors. This meeting is also known as a 341 hearing.

Many people are nervous about the 341 hearing, but there's really nothing to worry about. It's just an opportunity for the bankruptcy trustee to confirm the information provided in your petition and accompanying financial documents.

Creditors aren't required to attend, but if they do, they'll have a chance to ask questions about your finances. Just stay calm and answer honestly.

Does bankruptcy wipe out your debt?

Filing for bankruptcy isn't like waving a magic wand and making your debts go POOF! Under federal law, some debts can't be discharged at all, such as child support, alimony payments, federal student loan debt, and fines owed to a municipal court or other government agency.

Chapter 7 eliminates all dischargeable debts, giving you a fresh start financially. If you file for Chapter 13, you won't wipe away your dischargeable debts. Instead, you get to pay them back over an extended period of time.

Pros and cons of filing for bankruptcy

Bankruptcy advantages

Bankruptcy has many advantages for people struggling to manage their debt load. One of the most significant is the opportunity to wipe your financial slate clean. Once you get through the process, you'll be able to dedicate yourself to better financial habits.

When you file for bankruptcy, you also get an "automatic stay." It's a rule that prevents creditors from suing you or engaging in other collection efforts until your bankruptcy case is resolved.

Another advantage of bankruptcy is that it's a way to deal with every creditor at once instead of one by one. You could contact each creditor and ask to settle your debt, but that process is stressful and time consuming. Filing for bankruptcy is much less of a hassle.

Best of all, you get a court-appointed representative who communicates with your creditors and handles every aspect of the process. This person is known as a trustee. Allowing someone else to communicate with your creditors can make it a lot easier to reset your finances.

Bankruptcy disadvantages

One of the main drawbacks of filing for bankruptcy is the cost. Hiring an attorney typically costs between $1,300 to $3,000 depending on whether you file for Chapter 7 or Chapter 13 protection. This is in addition to the filing fee.

You may also have to pay other administrative fees as your case progresses. For example, it costs $11 to have a document certified by a federal court.

Another disadvantage of filing for bankruptcy is that it typically takes several months to resolve a case. If you file for Chapter 13, you'll also spend the next 3 to 5 years making payments according to your proposed plan.

Depending on your financial circumstances, you could lose some of your assets as well. For example, if you have $25,000 in vehicle equity, you may not be able to keep your ride if you're using the federal bankruptcy exemptions that max out at $4,450.

Bankruptcy can also damage your credit going forward. Depending on the type of bankruptcy you file for, it can stay on your credit report for up to 10 years. This negative info can result in lenders declining a future loan application or charging you a higher interest rate. 

Should you file for bankruptcy?

Bankruptcy isn't for everyone. If you're not sure if it's right for you, speak to an experienced bankruptcy attorney as soon as possible.

If you decide against bankruptcy, there are three main alternatives:

• Negotiate with creditors: if you contact your creditors, you can try to negotiate a settlement on each account.

• Debt consolidation: combining your debts into a single loan may make it easier to pay off debt. This option works best if you still have a decent credit score, as you'll need to qualify for a consolidation loan.

• Credit counseling: some nonprofit organizations offer credit counseling. If you choose to participate, a trained counselor can help you make a plan for tackling your debts and getting your finances under control.

The bottom line

• Bankruptcy is a legal process that can help you get back on your feet if you're experiencing financial difficulties.

• You can file a Chapter 7 bankruptcy or a Chapter 13 bankruptcy.

• Bankruptcy doesn't necessarily eliminate every debt you have, but it helps make your debts more manageable.