Is It Bad to Go Bankrupt? What to Know Before Filing

Bankruptcy is a legal process under federal law, supervised by U.S. bankruptcy courts, offering individuals a path to address overwhelming financial obligations and achieve relief from unmanageable debts. It aims to balance the debtor’s need for a fresh start with creditors’ rights. Filing for bankruptcy carries significant implications and requires careful consideration.

Common Types of Individual Bankruptcy Filings

Individuals primarily utilize two main types of bankruptcy filings: Chapter 7 and Chapter 13. Each chapter serves a distinct purpose and operates differently to provide debt relief.

Chapter 7 bankruptcy, or “liquidation bankruptcy,” allows for the discharge of most unsecured debts like credit card balances and medical bills. A court-appointed trustee may sell non-exempt assets to distribute proceeds among creditors. Individuals with limited income and few assets often file under Chapter 7 for a swift discharge, typically within a few months.

Chapter 13 bankruptcy, a “wage earner’s plan” or “reorganization bankruptcy,” provides a framework for individuals with regular income to create a repayment plan for debts over three to five years. Debtors retain property, including homes and vehicles, by making scheduled payments through a court-approved plan. This chapter is often chosen by those with valuable assets or income exceeding Chapter 7 limits.

Determining Eligibility to File

Before filing for bankruptcy, individuals must meet specific eligibility requirements. For Chapter 7, the “means test” assesses if a debtor’s income is low enough to qualify. This test compares the debtor’s current monthly income, averaged over the six months prior to filing, against the median income for a similar household size in their state.

If the debtor’s income exceeds the state median, additional calculations allow for deductions of certain living expenses, such as housing, transportation, and healthcare costs, to determine disposable income. If this remaining disposable income is insufficient to repay a meaningful portion of unsecured debts, the individual may still qualify for Chapter 7.

All individual bankruptcy filers must complete pre-bankruptcy credit counseling from an approved organization within 180 days before filing their petition. This counseling explores alternatives to bankruptcy and provides financial management education. A certificate of completion must be filed with the court.

Gathering comprehensive financial documentation is an additional preparatory step. This includes tax returns for recent years, pay stubs or other proof of income for the preceding six months, and recent bank and retirement account statements. Debtors also need to compile lists of all assets and liabilities, including details on secured debts like mortgages and car loans, and unsecured debts such as credit card balances and medical bills.

The General Filing Process

After eligibility is determined and financial information compiled, the formal bankruptcy process begins with submitting a petition and various schedules to the court. These documents detail the debtor’s financial situation, including income, expenses, assets, and debts. Filing the petition immediately triggers an “automatic stay,” a legal injunction that temporarily halts most collection actions by creditors.

The automatic stay prevents creditors from initiating or continuing lawsuits, wage garnishments, foreclosures, or repossessions while the bankruptcy case is pending. The stay’s duration varies, lasting for the length of the proceeding, from a few months in Chapter 7 to several years in Chapter 13. Creditors who violate the automatic stay can face legal penalties.

The “meeting of creditors,” or 341 meeting, is held approximately 20 to 40 days after the petition is filed. During this meeting, the debtor appears under oath before a bankruptcy trustee and any attending creditors. The trustee verifies information in the bankruptcy petition and schedules, clarifies details, and asks questions about the debtor’s financial affairs.

Following these procedural steps, if the debtor has met all requirements, the court issues a “discharge” order. This order legally releases the debtor from personal liability for most debts. The discharge prevents creditors from taking further collection actions on those specific debts, offering a fresh financial start.

Treatment of Debts and Assets

During bankruptcy, the treatment of debts varies based on their nature. Most unsecured debts, such as credit card debt, medical bills, personal loans, and past-due utility bills, are dischargeable.

However, certain debts are not dischargeable under bankruptcy law. These include most student loans, recent tax obligations (less than three years old), child support, alimony, and debts incurred through fraud or willful and malicious injury. Court fines and criminal restitution also fall into this category.

Regarding assets, “bankruptcy exemptions” allow individuals to retain a certain amount of property. These exemptions vary but protect essential items like a primary residence up to a certain value, a vehicle, household goods, tools of trade, and retirement accounts. Specific exemptions are determined by federal law or state statutes, depending on where the debtor files.

In Chapter 7, non-exempt assets may be sold by the bankruptcy trustee to repay creditors. Chapter 13 allows debtors to keep all their property, whether exempt or not, provided they include the value of their non-exempt assets in their repayment plan. This distinction often influences a debtor’s choice of bankruptcy chapter.

Credit Report Implications

Filing for bankruptcy has a significant impact on an individual’s credit report. The bankruptcy filing is recorded as a public record item, remaining on credit reports for a long period. A Chapter 7 bankruptcy stays on the credit report for 10 years from the filing date, while a Chapter 13 bankruptcy remains for seven years.

This public record entry can cause a significant drop in credit scores. The extent of the score reduction depends on the individual’s credit standing before filing; those with higher scores experience a greater decline. This lowered credit score signals increased risk to potential lenders, making it challenging to obtain new credit immediately after bankruptcy.

Individuals face difficulties securing new loans, credit cards, or mortgages in the immediate aftermath of a bankruptcy discharge. Lenders view a recent bankruptcy as a strong indicator of financial instability. While the negative impact lessens over time, the presence of bankruptcy on a credit report can affect interest rates and approval odds for several years.