A Quick Overview of Bankruptcy for Consumers
Bankruptcy is the legal procedure that allows individuals, businesses, and other organizations to discharge their debts when they become insolvent, unable to repay their debts. Consumer bankruptcy serves 2 main objectives:
- to give debtors a fresh start, and
- to pay creditors as much as possible from the debtor's bankruptcy estate without unduly burdening the debtor.
The other objective, given more prevalence with the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, is to prevent fraud and abuse.
The 2 major types of consumer bankruptcy arise from the differences in the legal code that governs each type, and are named according to the chapter of the applicable code — Title 11 of the U.S. Code.
Chapter 7 is usually filed by individual debtors with low incomes, and is a liquidation of any of the debtor's assets not exempt from liquidation by state law — or federal law if state law allows — to pay creditors. Chapter 7 bankruptcy is the most common form of bankruptcy, consisting of more than half of all bankruptcy filings. Chapter 13 is filed by debtors who have an income that exceeds their state's median income, or because they want to keep certain property, and allows them to repay at least a part of their debt over a period of 3 or 5 years. More than 1/3 of the bankruptcy petitions are for Chapter 13. Chapter 11 is most often used by businesses, but some individuals must use it if their debts are larger than the limits for Chapter 13. The number of Chapter 11 petitions by individuals is usually less than 1%.
Before a individual debtor can file for bankruptcy, he must receive credit counseling from an agency approved by the U.S. Trustee. Generally, the credit counseling will last an hour or so; it can be done over the phone or over the Internet, or the agency might have local classes. This credit counseling generally costs $50 or less. After the completion of the credit counseling, the debtor will receive a certificate of completion, and a repayment plan. The debtor does not have to, and may not be able to, do the repayment plan. However, both the certificate and repayment plan must be filed with the bankruptcy forms — otherwise, the debtor's case will be dismissed.
Filing for Bankruptcy
A consumer initiates bankruptcy by filing several bankruptcy forms, called the bankruptcy petition, with a bankruptcy court in the debtor's district. This commences the automatic stay, which stops most creditors from contacting the debtor, and stops most collection efforts. The forms require information about the debtor's current income and expenses, the name of each creditor and how much is owed them, and all the debtor's assets. The whole process, from beginning to end, is managed by the trustee, a court-appointed individual who is usually a bankruptcy lawyer. Debtors will mostly communicate with the trustee, not the court. The trustee looks at the bankruptcy forms to ensure that they are complete, determines whether the petitioner qualifies for bankruptcy, looks for evidence of fraud and abuse, and requests additional information when necessary.
The bankruptcy petitioner, in one of the forms, must determine his average income over the past 6 months. If this income is below the state median income, then he will be able to file for Chapter 7. If his income is above the median, then he must fill out a form that asks about his expenses and total debts — called the means test, because it will determine whether the debtor has the means to pay creditors at least part of the debt over the next 3 to 5 years. If he can, then he must file for Chapter 13.
Chapter 7 — Liquidation
A chapter 7 bankruptcy is a liquidation and takes about 4 to 6 months. The debtor can keep some property, called exempt property, but the rest of any unsecured property, if any, will be sold by the trustee to pay creditors. What and how much the debtor can keep is determined by state law, or, in a few states, the debtor can choose federal exemptions.
A chapter 7 petitioner has 3 choices regarding secured property:
- surrender the property by giving it back to the creditor;
- paying a lump sum to the creditor for the property, called a redemption;
- or agree to continue making payments to the creditor — known as reaffirmation.
Several months after the filing, the debtor must attend a creditors meeting, often called a 341 meeting, after Section 341 of the Bankruptcy Code that requires it. The creditors meeting takes place in or near the debtor's county, giving creditors a chance to ask questions of the debtor. However, since creditors usually cannot stop the bankruptcy, most creditors never show up. Typically, a creditors' meeting is a room full of debtors and their lawyers, and some creditors. Most of the creditors who do show up are local creditors. Credit card companies and major banks almost never send anyone. The trustee interviews each debtor, generally asking questions about the forms the petitioner filed. This interview rarely lasts longer than 15 minutes. Any creditors of the debtor at the meeting will have a chance to ask any questions, but they cannot usually stop the bankruptcy. Their best hope is to convince the trustee that the debtor committed fraud or abuse or is not otherwise entitled to relief from the creditor's debt.
After the creditors' meeting, the debtor will generally receive a discharge a few months later. However, before he can get a discharge, he must take a 2-hour budget counseling, or personal financial management counseling, by an agency approved by the United States Trustee.
The discharge eliminates most debts, including credit cards, loans, medical and legal expenses, and court judgments. However, certain debts, called priority debts, will still be in force after the discharge, which includes most taxes that were due within the past 3 years, child support and alimony, student loans, and debts for personal injuries or death resulting from the debtor's drunk driving.
Chapter 13 — Adjustments of Debts of an Individual with Regular Income
If a debtor's income exceeds the state's median income and he fails the means test, then he must file for a Chapter 13 bankruptcy. The basic difference from a Chapter 7 bankruptcy is that the debtor must repay at least some of his debts over a 3- or 5-year period, but, he will usually be able to keep all his property.
After formulating a repayment plan, the debtor must attend a creditors' meeting, where creditors may object to the repayment plan. The trustee may also raise any issues at the confirmation hearing.
The debtor must make at least 1 appearance before the judge, called the confirmation hearing, to present his repayment plan, which must be approved by the judge. If it is approved, then the debtor will make the payments to the trustee, who then pays the creditors according to the plan. The trustee also takes a portion of the payment as compensation, usually about 10%. If the plan is not approved, then the debtor must amend the plan and attend another confirmation hearing. Plans are often rejected because the debtor doesn't have enough disposable income after paying living expenses and required payments for nondischargeable debts, such as child support, to make the intended payments. After completing the repayment plan — and only after completing the repayment plan — the debtor receives a discharge.
Bankruptcy Listings in Credit Reports and How It Affects Credit Scores
A Chapter 7 bankruptcy can be listed in credit reports for up to 10 years from the date that the case was filed, and a Chapter 13 bankruptcy can be listed for up to 7 years after filing. Note that because a Chapter 13 case usually takes about 5 years from filing to discharge, a Chapter 13 bankruptcy can only be listed in credit reports for about 2 more years after the final discharge.
It might be surprising to learn that bankruptcy doesn't really hurt most people's credit scores that much. This is because bankruptcy generally discharges most unsecured, nonpriority debts, which includes almost all credit card debt and court judgments, and the consumer will not be granted another discharge for at least 4 years after that, and may have to wait up to 8 years if both bankruptcy filings are under Chapter 7. Thus, the consumer becomes a better credit risk. Moreover, people who file for bankruptcy already have bad credit, with missing or late payments, collections, judgments, and other negative items in their credit files. Furthermore, bankruptcy places a definite time limit on accounts. In other words, a delinquent credit card account will be listed in credit reports for up to 7 years after the account is closed! If the account is never closed, then it can remain on the credit report indefinitely.
After bankruptcy, if the consumer is wiser financially and is diligent in making payments, his credit will actually improve greatly over the 2 years following the final discharge, because credit scores, which most lenders and credit card companies use in determining the creditworthiness of individuals, depends mostly on financial data accumulated over the past 2 years, with more recent data have more influence on the score. See Credit Availability and Credit Scores After Bankruptcy for more info.