What is Bankruptcy? A Lengthy Legal Process With Significant Consequences

Whenever I see the word “bankruptcy,” I always hear a live studio audience in my head saying, “Awwww!” That’s probably because I’ve watched way too much Wheel of Fortune.

But when you deal with bankruptcy in real life, the situation is more than just momentarily disappointing; it can be downright devastating to your finances, and solving a few puzzles will do nothing to help you out of it. 

Bankruptcy is a legal process that allows individuals or businesses to eliminate or repay their debts under the protection of a court. Bankruptcy can be a lifesaver for people and businesses drowning in debt.

The several types of bankruptcy can suit whatever the filer needs, whether it be personal or business-related. I can walk you through the process of declaring bankruptcy (it’s much harder than Michael Scott makes it look on “The Office”), what you need to do to file, and the massive impact it will have on your credit.

Bankruptcy comes in multiple forms and is designed to help the debtor in different situations, be it an individual or business. There are three major categories: Chapter 7, Chapter 13, and Chapter 11. Each lets debtors do things a little differently as they deal with their debts.

Chapter 7 Bankruptcy 

Chapter 7 bankruptcy (a.k.a. “liquidation bankruptcy”) is one of the more drastic options, as it involves selling off all of a person or company’s assets to pay off their debts.

Here’s how it goes: a court-appointed trustee rounds up all your nonexempt assets (i.e., the things that aren’t protected by law, such as your retirement accounts) and uses the money to pay your unsecured creditors back, at least in part. It’s like having a big yard sale, but you’re unfortunately not getting any of the profits.

Not everything you own gets put on the auction block. Depending upon the state’s exemption rules, some of your stuff will be safe from the sell-off. What’s great about Chapter 7 is that it can wipe the slate clean on most of your unsecured debt, such as all those credit card balances and medical bills. However, you may still be on the hook for certain debts, like fines, penalties, and taxes.

Once a discharge paper is in your hand, you are free and clear of those debts — no more pesky collectors breathing down your neck. But don’t think it’s all sunshine and daisies, as not all debts get erased. You’re still on the hook for taxes, student loans, and child support, which will still be hanging around after the dust settles.

Chapter 13 Bankruptcy

Chapter 13, referred to as “reorganization bankruptcy,” is like getting a second chance to make things right without losing all your worldly possessions. When you earn a good, steady income but are still struggling to pay the bills, this may be your answer. 

Unlike Chapter 7, which forces you to liquidate many prized possessions, Chapter 13 may allow you to keep your house, car, and other valuable possessions while paying off your debts over time.

You can only go with this option if you’ve got some kind of regular income. It usually involves coming up with a court-approved repayment plan, usually over a period of three to five years. The plan prioritizes your bankruptcy fees, family support payments, taxes, unpaid wages, and secured debts like mortgages and car loans. 

Chapter 13 can wipe out — or at least knock down to size — those annoying unsecured debts, like credit card balances and medical bills, after taking care of the big stuff.

The best thing about Chapter 13 is that you don’t have to worry about the bank coming to take your home or car as long as you stick to the repayment plan. That makes it mighty attractive if you have a lot of assets at stake. 

Another big plus of Chapter 13 is that it can bring foreclosure to a screeching halt and provide you with a chance to get current on back mortgage payments by allowing you to wrap them into your repayment plan.

You get some breathing room to pull yourself together financially, and if you keep with the plan, the court may wipe out the rest of your eligible debts once you’re done. It’s like finding a ladder in a deep well — you’ve still got to climb, but at least you’ve got a way out.

Chapter 11 Bankruptcy 

Chapter 11 is often referred to as “reorganization bankruptcy.” It is usually used by businesses that find themselves up a financial creek without a paddle and yet want to keep the ship afloat. This chapter gives your business a second chance at life by letting you reorganize your debts and operations so you can keep the place open and the lights on. 

It is a powerful tool that enables you to renegotiate how much you owe, get rid of the things pulling your business down, and emerge on the other side as a leaner and meaner fighting machine.

When your business files under Chapter 11, you work up a reorganization plan that describes how and when you will pay your creditors.

Now, this plan isn’t a free pass — it’s got to get the thumbs up from both the bankruptcy court and the creditors. Renegotiating terms with lenders, downsizing to trim the fat, and selling off parts of the business that aren’t pulling their weight may be part of the plan. 

The primary consideration is recovering the business and giving creditors what is due to them. Chapter 11 has its advantages, to be sure. First and foremost, the company can continue to operate, which translates to saved jobs and grease for the wheels of commerce. 

Also, the moment you file, an “automatic stay” goes into effect. It’s an on-the-spot halt to any collection efforts by your creditors. But let’s not mince words: Chapter 11 can be a bear to wrestle with.

It is very labor-intensive and legally expensive, so you had better be ready to roll up your sleeves and dig in.

Filing (or petitioning) for bankruptcy is like setting out on a long trail — take it step by step to make sure everything gets done right and you get all the benefits that you are entitled to. I’ll walk you through the process so you will know just how to file for bankruptcy and not get your boots stuck in the mud.

Pre-Filing Counseling

First things first: before you can even think about filing for bankruptcy, you’ve got to go through mandatory credit counseling. You’ll sit down with an expert who’s going to give the once-over to your finances and determine whether there’s any other way to pay your debts without taking the bankruptcy route. You must complete this session with an approved agency no later than 180 days before filing.

1. Locate an Approved Agency: Find a government-approved credit counseling agency from the U.S. Trustee Program’s website. Ensure that it is on the up and up, has good ethics, and has a solid record for getting clients through pre-filing counseling, hopefully without tears or bloodshed.
2. Attend the Session: You will have to see a credit counselor in person, by phone, or even online — this takes an hour or two. The counselor will probe the details of your finances, such as your income, expenses, and other available means to escape debt without necessarily having to file bankruptcy.
3. Obtain a Certificate: Once you have finished your session and it has been filed, you will receive a certificate of completion valid for 180 days. Think of that as your ticket to apply for bankruptcy — the proof you have done your homework.

Pre-filing counseling helps you not only to understand what options you have but also confirms your eligibility to go ahead and file bankruptcy.

Filing the Petition

Filing your bankruptcy petition is where the rubber meets the road. It’s the step where you gather up all your financial information and lay it out for the court to see. Filing officially kicks off the legal side of bankruptcy, and everything you present should be in tip-top shape.

1. Gather Documentation: Scrounge around for every piece of paper (or electronic file) related to your income, expenses, debt, and assets. Please ensure everything is accurate and up-to-date, as one little mistake may lead to delay or worse.
2. Complete the Bankruptcy Forms: Now it is time to fill out the bankruptcy papers — also called schedules — that describe your financial situation to the court. Under Chapter 13, you will also prepare your proposed repayment plan. The documents can be complicated, so you may want to retain a bankruptcy attorney to help get you through the ordeal.
3. File the Petition: Take your completed petition and all the supporting documents to the clerk of the bankruptcy court and pay the filing fee. With this step taken, your case is on the record. An automatic stay goes into effect from this point onward — it puts the brakes on those pesky bill collectors.

The filing of the petition marks the start of the bankruptcy case and buys you some breathing room.

Meeting Your Creditors

After filing your petition, the next step is a “341 meeting” with your creditors. This is not a social call! Instead, it is when your creditors can probe into anything that interests them about your financial status and what you intend to do about it.

1. Trustee Sets the Meeting: This 341 meeting is scheduled by the bankruptcy trustee appointed by the court — usually between 20 and 40 days after you file your petition. You will receive a notice telling you when and where to show up, so be sure to mark it on your calendar.
2. Attend the Meeting of Creditors: When the big day rolls around, you’ll mosey on down to the location the trustee picked out. Be prepared for some hostility, as you will be answering the questions of both the trustee and your creditors. You do that under oath, under penalty of perjury. Be honest  —  give straight answers about your financial health, what you own, and what you owe.
3. Bring Documentation: Don’t forget to pack proof of your identity and all the financial documents you’ll need for verification. This usually means bringing paycheck stubs, bank account statements, tax returns, and proof of ownership for any property you’ve got. Forgetting anything just messes up and prolongs the bankruptcy case.

A creditors’ meeting should be as transparent as a mountain stream — all the parties concerned will have a fair shot at viewing the full picture of your finances.

DIY vs. Hiring a Professional

In truth, bankruptcy is a little like trying to find your way through a corn maze wearing a blindfold: it’s tricky, it can be intimidating, and it’s amazingly simple to get lost. 

So, suppose bankruptcy proceedings have you feeling more than just a little overwhelmed. In that case, you may want to reconsider tackling it on your own and bring professional bankruptcy attorney reinforcements along for the ride. Your decision will likely depend on how complicated your issues are, how much money you have to spend, and how confident you are in your ability to maneuver without an attorney. 

Let’s take a look at some pros and cons of each route.

Pros of DIY Bankruptcy Filing

• Cost Savings: If you’re on a shoestring budget, filing on your own can save a bundle since you will not need to hand out any money for attorney fees. These fine folks generally charge from $1,500 to $3,500 for Chapter 7 and from $3,000 to $6,000 for Chapter 13. For this reason alone, DIY bankruptcy may be more feasible when your wallet is feeling a little light. However, if your case is more tangled than a briar patch, the costs will probably escalate.
• Control Over the Process: Filing on your own puts you at the helm, and you can direct the process whichever way you will. You are in control at every stage to ensure things happen precisely as you plan.
• Learning Experience: Tackling bankruptcy yourself is like taking a crash course in financial management and the legal system. The knowledge you gain may come in quite handy down the road, whether you’re dealing’ with future financial decisions or — heaven forbid — another bankruptcy.

Cons of DIY Bankruptcy Filing

• Complexity and Risk of Errors: Bankruptcy law is about as simple as herding cats. If you’re not careful, you could make mistakes that might cost you the whole case. The hard truth is that do-it-yourself filers don’t fare as well — only 62.5% of Chapter 7 do-it-yourself filers get a discharge, compared with 96.8% with an attorney. And if you’re filing under Chapter 13, courts approve less than 1% of do-it-yourself repayment plans.
• Time-Consuming: Going it alone means you’re in for a heap of paperwork, research, and deadlines that may make your head spin if you’re not experienced with legal matters.
• Limited Legal Knowledge: Most laypeople do not know all the intricacies of the law and hence may lose their opportunities for exemptions or, even worse, their property. Without a pro in your corner, it’s really easy to get yourself in hot water.

Pros of Hiring a Professional

• Expert Guidance: An experienced attorney knows the bankruptcy law inside and out and can take care of your case with Swiss-watch precision. Their experience puts you in a better position to walk away debt-free.
• Reduced Stress: Let a professional take some of that load off your shoulders. Focus on getting back on your feet while the attorney handles all of the legal mumbo jumbo.
• Better Protection of Assets: A good attorney will maximize your exemptions to protect as much property and assets possible from creditors in a bankruptcy.

Cons of Hiring a Professional

• Cost: The biggest drawback is obviously the cost — attorney fees are really steep, adding to the financial burden you are already feeling. But, given a higher success rate and peace of mind, the cost is usually justifiable.
• Less Control: The problem of handing over your case to an attorney is that you will have less control over the process. If you happen to be one of those freaks who wants control over everything, then this might be a downside. For better-adjusted individuals, it’s a godsend.

Deciding between do-it-yourself and hiring a professional involves weighing the factors carefully. The DIY route can cost less, but the process is difficult. Professional know-how and guidance usually spell smoother sailing with superior results — if you can afford it.

Going bankrupt is like stepping in a street puddle: it’s messy, and it’s going to leave your credit soiled. Bankruptcy may eventually give you a break from those debts nipping your heels. Still, it will also create credit bruises that take some time to heal — especially when it comes to patching up your credit score and getting your finances back in order.

Short-Term Credit Consequences 

When you drop the bankruptcy bomb, your credit score is going to take a plunge. We are talking 100 to 200 points, depending upon how high you were sitting beforehand. But if your score was looking like last year’s scarecrow — beat up and weathered — because of defaults, charge-offs, and collections, then the fall might not be quite as steep.

But don’t kid yourself — that sort of fall usually drops you down into the badlands of credit, making it tougher to get a decent loan or even a credit card. Bankruptcy’s a red flag to lenders, landlords, and even employers.

The bankruptcy black mark is going to haunt your credit report — 10 years for Chapter 7 and seven years for Chapter 13. During that period, any lender, employer, or landlord that looks at your credit is going to see that mark and may shrink away from taking a chance on you.

This chart shows how long bankruptcy will stay on your credit report compared to other negative items:

At the least, it means you may face higher interest rates, larger security deposits, or outright slamming of doors when applying for credit or anything else.

Still, there’s a silver lining: The sting of bankruptcy fades over time. The more time that has passed, the less oomph it’ll carry. You can soften the blow sooner, however, by proving that you learned your lesson and paying new credit on time, keeping those balances low, and rebuilding your credit steadily. Eventually, you’ll leave bankruptcy blues behind.

Long-Term Credit Recovery

Rebuilding your credit after bankruptcy is a lot like fixing a broken fence: it takes time, patience, and a steady hand. To rebuild credit, here are some tips to get the job done:

• Obtain a Secured Credit Card: These are the training wheels of credit. You put down a deposit, let’s say $500; that becomes your credit limit. Use it responsibly — meaning pay it all off each month — and you’ll start building a good credit history.
• Become an Authorized User: Talk a friend or family member with good credit into adding you to their credit card account as an authorized user. All that good payment activity spills over onto your credit report, giving your score just that little boost it needs to get it going. A pot of strong coffee does the trick for me.
• Credit-Builder Loan: A credit-builder allows you to borrow money that the lender immediately puts into a safe account. You cannot get your hands on the funds until you pay off the loan. The good part is that the lender reports all your (hopefully on-time) payments to the credit bureaus, and before you know it, your score will show new signs of life.
• Check Your Credit Reports: Keep an eye on all your credit reports, looking for any errors or funny business that can drag down your score. If you do find some suspicious items, dispute them through the credit bureaus and make sure your reports are squeaky clean. 
• Set a Budget and Stick to It: The name of the game is living within your means. Set up a budget that will keep your spending within limits so you won’t wind up in another heap of debt. 
• Pay All Bills on Time: Pay at least the minimum on credit cards each month. Pay your other bills, such as utilities and rent, on time. Timely payment is the most effective way to show lenders that you are on the right path. It can work wonders for your credit score. 
• Limit New Credit Applications: Do not apply to every credit card that sends you an offer! Each time anyone hard checks your credit, some points come off your score. Be selective: Just focus on maintaining a few accounts and building them up nice and slow.

Rebuilding your credit after bankruptcy may feel like trying to patch a leaky roof in the driving rain — tough work, but it can be done. With some strong effort and a little discipline, you can get your credit back in shape. Think how wonderful it will feel when you can square your shoulders and step into the world with good credit again. 

Legal Protections and Restrictions 

Once you get a bankruptcy discharge, creditors have to back off and leave you alone. In Chapter 7, most of your unsecured debt just gets wiped clean at the moment of your discharge.

Along with that discharge comes an automatic injunction, kind of like a net that keeps the creditors out of your hair. They can’t go after you through lawsuits, they can’t garnish your wages, and they’d better not even think about bothering with those collection calls. It’s a legal barrier that gives you some peace and quiet while you start fresh.

But before you think all your troubles are behind, remember this: Bankruptcy does not wipe out all debts. Some debts are as stubborn as a mule and just won’t budge. Among them are student loans, domestic support obligations, alimony, and certain tax debts. Those are some of the ones you’ll still be on the hook for, even after the discharge.

Here’s a word to the wise: if you don’t play by the rules of your bankruptcy plan or if you try pulling a fast one on your creditors, that discharge can be yanked right out from under you faster than you can blink.

Bankruptcy can save you from drowning in debt, but it’s not a step to be taken lightly. It will knock down your credit score, make it tough to get new credit, and might just cost you some of your nonexempt property. 

So before you hitch your boxcar to that train, you may want to consider some less drastic ways of getting out of debt, such as professional credit counseling, debt consolidation, or negotiating with your creditors.