How does bankruptcy work?

Debt, even overwhelming debt, is 100% solvable. So you're smart to be researching bankruptcy and other solutions like debt consolidation and debt resolution. Once you understand your options, you can confidently make the right decision for your situation. 

What is bankruptcy?

Bankruptcy is a court-ordered solution to unaffordable debt. When you declare bankruptcy (file a bankruptcy petition), a bankruptcy judge determines how much you can repay and how you'll do it. Creditors are bound by the court's decision, and they must release you, the debtor, from eligible debts once you complete the bankruptcy requirements.

Most people file either Chapter 7 bankruptcy, in which debtors may have to give up some of the things they own to clear their debt, or Chapter 13, in which they give up some of their income for three or five years. (There are other forms of bankruptcy, but they are rare and not covered here.)

Some of the benefits of filing for bankruptcy protection are:

• Puts a stop to most collection and foreclosure efforts

• You might be able to walk away from your debts

• You might be able to walk away from older tax debts

• You might get partial forgiveness of debts that can't be wiped out

The drawbacks include:

• You might have to give up some things that you own

• You might have to commit all of your disposable income to your plan for a few years

• Chapter 13 has a relatively low success rate (about half)

• You'll have to pay court fees, probably attorney fees, possibly ongoing program fees, and possibly some of your debts

• Bankruptcy is a public record

• Bankruptcy affects your credit standing and some of the prices you'll pay for several years after you file

The bankruptcy process 

You can file for bankruptcy on your own or with the help of a lawyer. Unless you're very patient, good at filling out forms, and extremely comfortable with financial terms and legal proceedings, you'll want to find a bankruptcy attorney. 

Before you're allowed to file, the law requires you to complete a special pre-bankruptcy credit counseling session with an approved agency. It takes about an hour and costs about $50. You'll receive a completion certificate, which you'll submit with your bankruptcy petition. 

Once you've finished counseling, you'll follow a series of steps.

Step 1: Assessing your financial situation

To determine what type of bankruptcy is right for you, you'll list your assets, debts, and income. 

Assets are your possessions, including real estate, cars, household goods, collections, jewelry, investments, bank account balances, retirement accounts, and anything else that you own. 

You'll have to determine which assets are considered exempt in your state. These are assets that you won't have to surrender to clear your debts. 

Debts include loans, accounts, collections, medical balances, legal judgments, student loans, and anything else you owe ‌anyone. Note which debts are secured by property (like auto loans and mortgages) and which are unsecured (like credit card balances).

Finally, add up your sources of income. You'll need to know your income to take a bankruptcy means test. If you pass the means test (because your income is low enough), you can file Chapter 7 or Chapter 13, and you'll have to decide which one is right for your situation. If your income is too high for Chapter 7, you'll have to go with Chapter 13.

Step 2: Gathering financial documents

Your next step is collecting paperwork. Here are some of the items that are typically required:

• Pay stubs 

• W-2 forms (last two years) if you're employed

• Tax returns (last two years)

• Profit and loss statements (last two years) if you're self-employed

• Financial statements (last two years) if you're self-employed

• Account statements for any assets you own

• Vehicle registration

• Real estate appraisal if you have one

• Proof of expenses you're responsible for, such as child support, spousal support, restitution, judgments, or IRS installment plans

Step 3: Filing for bankruptcy

The United States Courts Bankruptcy Forms webpage has the official bankruptcy forms you need to file for Chapter 7 or Chapter 13 bankruptcy. The whole package is the bankruptcy petition and includes the voluntary petition, financial schedules, and a course completion certification.

You or your attorney will fill out the forms and submit them to the bankruptcy court with your supporting documents. You'll also pay your filing fees, a little over $300 in most cases. If you file Chapter 7 and your income is low enough to qualify, you can apply to have this fee waived.

Step 4: Automatic stay

One of the benefits of declaring bankruptcy is that creditors immediately have to stop trying to collect from you, evict you, shut off your utilities, or foreclose on you. This is called an automatic stay. If a creditor wants to resume its eviction, foreclosure, or collection process, it must ask the court to lift the automatic stay. The court may grant this request, so it's important for you to stay on top of your case and follow the law exactly.

Step 5: Meeting of creditors

Before your bankruptcy can proceed, you'll need to attend a meeting of creditors, also called the 341 hearing. The debtor's presence is required (that's you). Your attorney doesn't have to attend but they generally do. A bankruptcy trustee runs the meeting of creditors, and it's usually held in a conference room, not a courtroom. It may only last a few minutes and is often just a formality. 

Creditors are allowed to ask you questions about your financial situation. Expect to explain how you calculated your income, paid your taxes, spent your money, and valued your property. Creditors could also ask you about recent purchases or whether anyone owes you any money. The questions your creditors ask, if any, will depend on the specifics of your situation.

The bankruptcy trustee is the person who reviews your petition and supporting documents and runs the day-to-day bankruptcy process. If you file Chapter 7, the trustee sells your non-exempt property and pays your creditors. In a Chapter 13, the trustee receives your plan payments and distributes the money to your creditors. 

Step 6 (Chapter 13 only): Making your payments

When you file Chapter 13, your attorney proposes a plan to repay at least some of your debt. Depending on your income, you'll make regular payments for three or five years. You can pay the trustee directly or through payroll deduction. To succeed, you must make your payments on time and comply with other requirements like submitting copies of your tax returns every year.

Succeeding at Chapter 13 means learning to live on a budget because you're not allowed to take on additional debt without the trustee's approval. 

Step 7: Discharge of debts

When a debt is discharged, that means it's forgiven. Before your debts can be discharged, you must complete pre-discharge debtor education from an approved provider. For Chapter 7, you'll have surrendered your non-exempt property. For Chapter 13, you'll have made all required payments into the plan. 

The court will notify you by mailing out a document called an order of discharge. Your discharge wipes out any remaining eligible balances. However, there are some types of debt that can't be discharged in bankruptcy. They include:

• Payments for spousal or child support.

• Most student loans and tax debt.

• Debts that the court decides can't be discharged.

• Fines, penalties, and criminal restitution.

• Debts that weren't listed correctly during the bankruptcy process.

• Loans owed to a retirement plan.

• Money owed as a result of injuring someone while driving under the influence.

• Debts covered by a reaffirmation agreement, which means you agreed to keep paying them (for instance, you agreed to continue making auto loan payments so you could keep your car).

It's important to be truthful and cooperate with the trustee during your bankruptcy. Otherwise, the bankruptcy court can revoke or deny your discharge.

What's next

1. Bankruptcy is a serious solution to big debt problems. Look over your finances and decide if you need to take this kind of action. You might also want to take a look at other strategies, including debt consolidation and debt resolution, to find out which path makes the best sense for your situation. 

2. Pull your documents together.

3. Find a bankruptcy attorney. Many offer free consultations to help you decide if filing is right for you.