What happens when you can’t pay your debts?
Well, once upon a time such as in ancient Greece you might have ended up in debt bondage.
Being a debt slave meant that you and sometimes your family would work for the person you
owed money to pay off your debt.
This is distinct from slavery, since you were freed once your debt was paid.
Later on in history, like in Victorian England, the poor were sent to horrific debtors’
prison and would only be released when their debt was paid in full by friends or family.
Other debtors’ prisons functioned similar to workhouses and a debtor worked off not
only their debt, but their room and board to be freed.
Currently, many countries now practice some form of bankruptcy which reigns in debt and
allows debtors to get a fresh start financially.
That’s not to say that questionable debt practices no longer exist; in some parts of
the world, such as South Asia and Sub-Saharan Africa debt bondage is still practiced.
The United Nation estimates that 8 million people are trapped in bonded labor.
Thankfully, there are many groups working to improve lives of and free people from what
the UN considers a ‘modern day slavery practice’.
However, today we’re discussing the basics of how personal bankruptcy functions in the
United States.
There are actually 6 different possible types of bankruptcy in the US.
They are each named for the portion of the Bankruptcy Code they are found under: Chapter
7, Chapter 9, Chapter 11, Chapter 12, Chapter 13 and Chapter 15.
Each Chapter addresses a different type of bankruptcy, for example Chapter 9 applies
to the bankruptcy of municipalities such as towns or cities.
The majority of individuals file one of two types of bankruptcy, Chapter 7 or Chapter
13.
People choose to declare bankruptcy for a myriad of reasons.
Many financial literacy websites such as Investopedia state that a significant amount of people
declare bankruptcy each year in the US due to costly health events.
Two other major reasons why people end up filing bankruptcy are due to losing employment
and poor financial choices, including excessive spending.
Bankruptcy is a legal proceeding, where an individual, spouses together, or a business
makes a formal request to a federal court, declaring that they are unable to repay outstanding
debts.
Each type of bankruptcy requires different forms and procedures.
For Chapter 7 bankruptcy the debtor petitions the court that they are unable to pay their
debts.
So let’s walk through how a Chapter 7 bankruptcy could proceed:
Meet James.
He has some student loans from getting his college degree, some credit card debt, medical
debt from emergency ER visit, and until 5 months ago, a decent job.
Unfortunately, after being laid off, James quickly ran through the small amount of saving
he had.
While James has moved into his parent’s basement to save money and has been working
some temporary gigs while he continues to look for a permanent job in his industry,
he’s months behind some bills.
James decides to file bankruptcy.
The first step is that James must undergo government mandated credit counseling.
The US Trustee's Office maintains an approved list of agencies that provide counseling at
reasonable cost.
Debtors are required to file a certificate of counseling completion along with their
other bankruptcy forms.
Sometimes going through the pre-bankruptcy credit counseling helps a debtor to develop
a plan to resolve their debts without going into bankruptcy.
James’ second step is to file bankruptcy forms with the court and pay fees associated
with the cost of his case.
In some instances, debtors can request a fee waiver.
Generally, mandatory bankruptcy court fee costs between $300-$400 USD.
The bankruptcy paperwork James has to fill out is pretty extensive; it includes forms
listing financial information, assets, income, expenses and property exemptions.
An important requirement for a Chapter 7 bankruptcy is that the debtor does not have sufficient
income to pay even at least a portion of their debts.
If the debtor has enough income, they must file under Chapter 13 bankruptcy, which we’ll
discuss shortly.
The decision of which type of personal bankruptcy to File Chapter 7 or Chapter 13 is determined
through The Bankruptcy Means Test which calculates the debtor’s income, expenses and debts
to see if any repay is possible.
Once James has completed the filing part of the bankruptcy process, an automatic stay
goes into effect.
This stay stops most debt collection efforts, which James really appreciates, constant calls
from creditors have been making him anxious.
In addition to halting communication from creditors, automatic stays stop wage garnishments.
In some cases they even temporarily stop repossession, foreclosure or eviction proceedings for the
duration of the debtor’s case, allowing time for the debtor to come to an agreement
with the creditor.
After James files paperwork, the court appoints a trustee to handle his bankruptcy case.
The trustee reviews James’s paperwork.Then his assets become part of the bankruptcy property
and are scrutinized and evaluated by the trustee.
The fourth step in the bankruptcy process is the meeting of creditors held by the court.
At the meeting, James under oath answers questions about his finances from the trustee and any
creditors who choose to show.
Once the trustee gathers and reviews all applicable information pertaining to James’ debt, the
court makes a decision on whether or not James is eligible for Chapter 7 bankruptcy protection.
If the court denies eligibility, James may have the option to file for Chapter 13 bankruptcy.
Thankfully the court granted James’ petition.
The trustee now decides which of James’ assets to sell off for money to pay his creditors.
Some assets are considered exempt from liquidation such as the house the debtor lives in as long
as the mortgage is current, household furnishings or a personal vehicle up to a specified value--basically
essential assets needed to maintain a life.
Common assets that are not considered exempt are investments, jewelry, valuable artwork
or collectible items such as a stamp collection.
Each bankruptcy case is unique and the assets sold depend on the facts in the individual
case.
Also, different states set their own rules as to what assets are exempt and non exempt.
Seventeen states allow debtors an alternative choice, they can either choose the state exemption
system or opt to follow another set of exemptions created by Congress, called the federal bankruptcy
exemptions.
If a debtor lies or tries to hide assets and is caught, the debtor can face penalties and
may not have their debts discharged.
In some cases, debtors can face criminal charges for fraud for providing false information
when filing for bankruptcy.
Depending on the individual situation, the debtor may be able to negotiate with the trustee
to keep certain nonexempt property if they come up with enough cash or are willing to
give up exempt property instead.
So James has to sell his coin collection to pay towards his debts, but is able to keep
his paid off, few years old commuter car.
Depending on the state a debtor may only receive an exemption for the functional version of
an essential item.
For example, if James owned outright a $40,000 car sports car, his trustee may sell the car
for $40,000, use $35,000 to pay towards James’s debts and give him a $5,000 credit for an
exempt car.
At this time James must resolve any secured debt by either returning the collateral or
property or reaffirm the debt, meaning that he will continue to make payments.
If James didn’t own his car outright and has an overdue car note, he would have to
let the car be repossessed or get current on the car note and continue to make payments.
Obviously, if it’s an expensive sports car, James will have to let it go, but if it's
a budget commuter car, it may behoove James to figure out a plan to keep making payments.
The final step James must take is to complete a debtor’s education course and file a certificate
with the court confirming completion.
Then generally within 3-6 months after James has filed, he will receive his bankruptcy
discharge notification and the automatic stay is lifted.
Within a few weeks of receiving his discharge, James’ case is officially closed and his
unsecured debts--his credit card and medical debt are cleared, he will continue to have
to pay off his student loans.
The public record of a Chapter 7 bankruptcy remains on James’ credit report for 10 years.
For Chapter 7 bankruptcy, some debts are not eligible to be discharged.
Non dischargeable debt includes spouse and/or child support, most student loans, and income
tax debt.
Common debts that are wiped out are credit card balances, personal loans and medical
bills.
If money is owed on a secured debt, which means that the debt has collateral, such as
a mortgage or vehicle loan, the debtor has a choice if they are current on their payments:
they can allow the creditor to repossess the property, thereby discharging the debt or
they can keep the property and continue to make payments under the original contract.
Debtors who don’t have any valuable assets and only own exempt property, simply have
their debt discharged and don’t repay any part of their unsecured debt.
The majority of Chapter 7 bankruptcies filed for are granted.
For Chapter 13 bankruptcy, the debtor petitions the court with a different request, instead
of selling off assets and discharging debt like Chapter 7, debtors seek to reorganize
their debt and establish a 3-5 year plan for repayment.
Chapter 13 payments are then made monthly to the court appointed trustee, effectively
consolidating debts into one single amount.
The trustee then distributes the money to the debtor’s creditors, and the debtor doesn’t
have any direct contact with creditors.
The Chapter 13 bankruptcy process may allow debtors to stop foreclosure proceedings and
catch up on delinquent mortgage payments over time.
It also allows debtors to negotiate and possibly set new terms for vehicle repayment and to
lengthen payment plans for past due income taxes, child support and spousal support.
Meet Nicole.
She has a car note, a mortgage on a small house and a pretty good job.
Unfortunately last year, Nicole had a medical emergency and missed a few months of work,
wiping out her savings, which forced her to mainly live on her credit cards.
Even worse, the medical costs exceeded Nicole’s medical insurance.
Thankfully, Nicole has recovered and is back to work fulltime.
However, at this point she’s behind on her mortgage, car note, some of her credit cards
and has a lot of medical debt.
When considering filing for Chapter 13, Nicole opts to hire a bankruptcy lawyer.
For both Chapter 7 and Chapter 13, many debtors hire a bankruptcy lawyer to assist them through
the process, which can be confusing.
Hiring a lawyer is more common with Chapter 13, because it tends to be more complicated.
A bankruptcy lawyer can cost anywhere from $200 for a basic meeting up to around $6,000
if the lawyer appears in court for you or your case is complex.
In Nicole’s case, she feels like it’s worth it to shell out a few thousand dollars
to try to prevent the foreclosure of her house.
Like with Chapter 7, the first step in the Chapter 13 bankruptcy procedure is that Nicole
must undergo government mandated credit counseling.
Then she files bankruptcy forms with the court and pays fee associated with the cost of her
case.
However, as a part of her filing Nicole submits a debt repayment plan which is often developed
during credit counseling.
Also, it’s likely Nicole’s lawyer would help her create a debt repayment plan.
Once Nicole has completed this part of the process, an automatic stay goes into effect
limiting communication from creditors and temporarily halting the foreclosure of her
house.
The court appoints a trustee to Nicole’s case.
Next, the court holds a meeting of creditors and then within 45 days a Chapter 13 confirmation
hearing is also held by the court.
For both court appearances, Nicole’s lawyer goes with her.
Nicole’s lawyer has also been in negotiations with her creditors to get her the best outcome
possible.
At the Chapter 13 confirmation hearing Nicole’s repayment plan is reviewed.
Creditors may ask for clarification and raise concerns or objections to the repayment plan.
By the end of this type of hearing the debtor’s plan is confirmed, the confirmation hearing
is continued for another day, allowing time to redo the payment plan or negotiation between
a debtor and creditor.
In some cases, at the confirmation hearing the bankruptcy case is dismissed or converted
to a Chapter 7 bankruptcy.
Luckily, at her first confirmation hearing, Nicole’s repayment plan was accepted.
Then the court considered whether or not to have Nicole’s Chapter 13 monthly payment
be deducted directly from her paycheck.
They opted to let her make the monthly payment to the trustee on her own.
For the next 5 years Nicole will continue to make a monthly pay on her debts.
After 5 years, if Nicole has remaining credit card and medical debt, it’s discharged.
She will continue to make mortgage payments for her house.
During the 5 years, Nicole was able to complete her car loan and she now owns her car outright.
In general, Chapter 13 debtors must petition with repayment plans that can take between
3-5 years to pay off.
Once the years of repayment are completed, the record of the Chapter 13 bankruptcy stays
on the debtor’s credit report for 7 years.
During the 3-5 year repayment process, the debtor isn’t allowed to incur any more debt,
such as a new vehicle loan, without court approval.
Also debtors must maintain insurance on any collateral or properties.
So why do people file bankruptcy instead of seeking other options, especially since declaring
bankruptcy affects credit scores?
Having a record of bankruptcy makes it hard for a consumer to open new accounts, obtain
unsecured loans or credit cards and sometimes makes them ineligible to purchase a vehicle
for several years.
Bankruptcies can even affect getting security clearances or professional licenses.
However, we’d like to stress that each bankruptcy is unique and there’s no one size fits all
answer; it utterly depends on the life situations the debtor is going through.
Dealing with creditors can be extremely stressful.
Others need a guided plan to begin rebuilding their financial health, sometimes bankruptcy
is simply the best option available.
No matter what your financial situation the best option for you right now is to click
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