What Is Bankruptcy? Definition, Types and What to Know
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Key takeaways
Bankruptcy is a legal tool to help consumers and businesses resolve overwhelming debt. It’s a complicated process that’s best taken on with the assistance of an attorney.
Chapter 7 and Chapter 13 are the two most common types of bankruptcy for consumers, while Chapter 11 is typically used for businesses.
Bankruptcy may make sense if your total non-mortgage debt exceeds 40% of your income and your path to pay it down is unclear.
Filing for bankruptcy can negatively impact your credit score and will stay on your credit report for seven to 10 years. However, you can begin to restore your score in as little as a few months.
There are alternative debt relief options to consider, like a debt management plan.
What is bankruptcy?
Bankruptcy is a legal process that can provide relief for people struggling to repay debts. Depending on the type of bankruptcy that’s filed, consumers can wipe out some amount of unsecured debt or enter a repayment plan with better payment terms.
A bankruptcy filing stops debt collection calls, debt lawsuits and wage garnishment. The process is complicated and hiring an attorney is advisable, but you’re likely to see some parts of your finances improve within six months of filing. It is possible to use bankruptcy to wipe out student loans, but it’s more difficult than other types of debt.
Is filing for bankruptcy right for you?
Filing for bankruptcy is never an easy decision, and you’ll have to weigh pros and cons for your particular situation. But in general, bankruptcy may be the best option if:
You see no way to pay off your debts within five years.
Your amount of debt (excluding a mortgage) is greater than 40% of your income.
You’re paying as much as you can toward your debts but not making progress.
Debt payments are preventing you from meeting other financial goals, such as saving for retirement.
If you’re considering bankruptcy, get free consultations from a bankruptcy attorney and a nonprofit credit counselor to better understand your finances and whether bankruptcy is the best option.
What are the types of bankruptcy?
The two most common kinds of consumer bankruptcy are Chapter 7 and Chapter 13. Chapter 11 bankruptcy is typically used by businesses.
Here’s a breakdown:
Chapter 7 bankruptcy
Known as “liquidation” since most unsecured debts are forgiven, Chapter 7 bankruptcy is the fastest and most common form of bankruptcy.
Best for: Consumers who have primarily unsecured debt, such as medical bills, credit card debt or personal loans.
Eligibility
You must pass the means test, which determines whether you qualify to file Chapter 7.
Cannot have had a Chapter 7 discharge in the past eight years or a Chapter 13 discharge in the past six years.
Cannot have filed a bankruptcy petition in the previous 180 days that was dismissed because you failed to appear in court or comply with court orders, or you voluntarily dismissed your own filing because creditors sought court relief to recover property they had a lien on.
Chapter 13 bankruptcy
Known as a “wage earner's” plan, Chapter 13 bankruptcy restructures debts into a payment plan over three to five years.
Best for: Those who have assets they want to retain, like expensive jewelry, or secured debts they want to get current on, like a mortgage.
Eligibility
You must have regular income.
Must be current on tax filings.
You cannot have filed for Chapter 13 in the past two years or Chapter 7 in the past four years.
You cannot have filed a bankruptcy petition in the previous 180 days that was dismissed for certain reasons, such as failing to appear in court or comply with court orders.
Chapter 11 bankruptcy
Called a “reorganization” bankruptcy, this chapter is typically used by corporations and businesses.
Best for: Businesses that want to keep operating.
Eligibility
Cannot have filed a bankruptcy petition in the previous 180 days that was dismissed because you failed to appear in court or comply with court orders, or you voluntarily dismissed your own filing because creditors sought court relief to recover property they had a lien on.
Do you need a bankruptcy attorney?
The short answer: Yes.
Bankruptcy is a long and complicated process. One form improperly filled out could result in the dismissal of your case, which means you would have to wait six months to file again. Find a bankruptcy attorney to help you navigate the process and ensure your paperwork is properly filled out.
Many bankruptcy attorneys will want payment before filing, but you have options to help pay for bankruptcy.
How long does bankruptcy stay on your credit report?
Filing for bankruptcy will stay on your credit report for up to 10 years.
But there is a bright spot: Your credit can start to improve within months of filing, and the change may be especially marked if you were already delinquent on your debts.
A 2014 report from the Federal Reserve Bank of Philadelphia found that those who filed Chapter 7 bankruptcy saw their scores improve from an average of 538 to an average of 620 on a 300-850 scale by the time their case was discharged, which is usually within six months.
There are also steps you can take to help recover after bankruptcy.
» LEARN: What is bankruptcy for Canadians?
What are alternatives to filing for bankruptcy?
Depending on the kind and amount of debt you have, you may have other debt relief options that could help resolve your debt.
Use this calculator to explore your debt relief options, such as a debt management plan from a nonprofit credit counseling agency, do-it-yourself methods and consolidation.
