Bankruptcy: What It Is, How It Works, and Types

What Is Bankruptcy?

Bankruptcy is a way to get a fresh financial start (as an individual or business) if you can’t repay your debts. Typically, this requires filing a petition with a bankruptcy court. From there, a judge decides whether you must liquidate any of your assets or if the debt can be restructured to satisfy as much of your obligation as possible.

How Bankruptcy Works

When you declare bankruptcy, you file a petition with a federal court. While you can technically do this on your own (also known as filing “pro se”), it’s not recommended. Bankruptcy law is complex, and a single mistake can significantly harm your case. Instead, consult a qualified bankruptcy attorney who can help you choose which type of bankruptcy to declare and how to navigate the legal process.

Once you file, an automatic stay takes effect, temporarily halting creditors from pursuing collection actions against you, including lawsuits, foreclosure, and wage garnishment.

A trustee is then appointed to oversee your case. You’ll need to disclose your assets, income, and debts, potentially in a 341 meeting (i.e., a meeting of creditors) depending on the bankruptcy chapter. This lets the trustee determine whether any of your assets should be sold (in liquidation cases) or if a repayment plan is needed (in reorganization cases).

At the end of the process, your qualifying debts will be discharged, meaning you’ll no longer be responsible for them as long as you satisfy the bankruptcy terms. However, a bankruptcy also stays on your credit reports for years, hurting your credit score and your ability to borrow money in the future.

Types of Bankruptcy Filings

Enacted by Congress in 1978, the Bankruptcy Code outlines different bankruptcy types for various situations. For example, Chapters 7 and 13 are the most common types available to individuals, while Chapter 11 bankruptcy is primarily used by businesses.

Chapter 7

Chapter 7 bankruptcy lets individuals discharge most types of unsecured debt, such as credit card balances and medical bills. However, you must first liquidate non-exempt assets to pay back as much of the debt as possible.

Non-exempt assets can include stocks, bonds, and other unessential valuables. In contrast, exempt assets, which are protected from the liquidation requirement, may include your primary home, furniture, and car.

Chapter 11

Chapter 11 bankruptcy lets businesses (and sometimes individuals with substantial debt) develop a plan to reorganize and repay their creditors over time. This can involve downsizing, renegotiating contracts, or selling assets—all while the business continues to operate. However, the business can’t expand its operations, take on new debt, or sell assets not specified in the reorganization plan without court approval.

To qualify, you must submit a reorganization plan within 120 days of filing the bankruptcy petition (though the court may grant extensions). The plan must then be approved by creditors and confirmed by the court.

Chapter 13

If you don’t qualify for Chapter 7 bankruptcy, consider Chapter 13. It allows you to restructure your debt under a new repayment plan that usually spans three to five years. Unlike Chapter 7, you’re not required to liquidate any assets, making it a better option if you want to keep otherwise non-exempt property.

That said, your debt won’t be discharged until you’ve completed the repayment plan. Furthermore, you must have regular income and less than $2.75 million in total debt to qualify.

Other Types of Bankruptcy

Less common forms of bankruptcy include:

• Chapter 9 bankruptcy: Chapter 9 is similar to Chapter 11, except it applies to financially distressed municipalities, including cities, counties, townships, and school districts. It lets them create a plan to repay creditors without the need to liquidate assets.
• Chapter 12 bankruptcy: Chapter 12 is designed specifically for farms and fisheries. It allows them to reorganize their businesses and devise a repayment plan while maintaining ownership of their land, equipment, and other essential assets.
• Chapter 15 bankruptcy: Chapter 15 handles cross-border insolvency cases, where a debtor’s assets and debts are spread across multiple countries. It was added to the Bankruptcy Code in 2005 to facilitate coordination between United States and foreign courts.

What Is a Discharge in Bankruptcy?

A discharge is a court order that officially absolves you from your outstanding debts after you’ve met the terms of your bankruptcy. In other words, you’re no longer responsible for the debts, and creditors can no longer come after you for them.

However, some debts can’t be discharged, including most taxes, child support, alimony, most student loans, court fines and criminal restitution, and personal injury caused by driving drunk or being under the influence of drugs. In addition, creditors with secured claims can still seize collateralized property (assuming there’s a valid lien).

Pros and Cons of Bankruptcy

Pros Explained

• Unsecured debt relief: Get a fresh financial start by eliminating unsecured debt you can no longer repay.
• Automatic stay: Stop creditor collection efforts (including lawsuits, foreclosures, and wage garnishments) during the bankruptcy process.
• Exempt asset protection: Some essential assets, such as your home and car, may be exempt from liquidation.

Cons Explained

• Significant credit damage: Bankruptcy stays on your credit reports for 7–10 years (seven for Chapter 13 and 10 for Chapter 7), making future borrowing more difficult.
• Loss of non-exempt assets and collateral: You may have to sell non-exempt assets, in addition to forfeiting collateral on secured debt.
• Some debt types are ineligible: Certain debts like child support and unpaid taxes are ineligible for discharge through bankruptcy.

Bankruptcy Alternatives

Before you resort to declaring bankruptcy, consider these alternatives:

• Negotiate with creditors: Many creditors would rather extend your repayment schedule, reduce your loan balance, or modify other loan terms than risk receiving little to nothing through a bankruptcy filing.
• Explore forbearance options: If you’re behind on mortgage payments, ask your lender if they’ll consider a forbearance (temporarily pausing payments) while you get back on your feet. They may prefer this to going through a long and costly foreclosure.
• Request an offer in compromise: If you’re behind on taxes, ask for an offer in compromise from the Internal Revenue Service (IRS). This lets you settle with the agency for less than you owe. You may also want to request a payment plan to spread your debt payments over a longer time frame.

The Bottom Line

Ultimately, bankruptcy can provide some much-needed financial relief if you’re drowning in debt. However, it’s not a decision to take lightly. You may be forced to sell assets and sustain serious credit damage that could make it harder for you to borrow money down the line.

Before filing, consider all your debt relief options, including negotiating with creditors and exploring loan modification. If bankruptcy is still the best option, consult a qualified attorney who can help you navigate this complex legal process and maximize your financial recovery.