What is Bankruptcy & How to Avoid It

“I. Declare. Bankruptcyyyyyy!”

As Michael Scott learned in “The Office,” getting rid of debt isn’t as simple as that announcement. Wouldn’t that be nice?

Many people think of filing bankruptcy as an easy way out. But these people have never filed bankruptcy.

In reality, bankruptcy is a drastic measure for shoring up your finances and getting your debt under control when you’ve exhausted all other options. And it comes with consequences — mainly a serious hit to your credit.

But it can also be a lifeline. Bankruptcy creates an orderly, sanctioned plan that tells you who you have to pay back and how much. That sense of order alone can be a relief for anyone staring into a pile of past-due bills.

We’ll explain what happens when you file for bankruptcy, how it works, the different types of bankruptcy, pros and cons, as well as how to avoid it altogether in this guide.

Understanding Bankruptcy

Bankruptcy is a legal process by which an individual, couple or corporation with significant debt is either relieved of that debt or allowed to pay it off under a specified plan.

That may sound really appealing if you’ve got debt up to your eyeballs, but realize that even after filing bankruptcy, you may still have to repay your debt.

While for some people, bankruptcy is better than having their wages garnished or their homes put into foreclosure, it should be a last resort for getting rid of debt.

But if you’re out of options, bankruptcy can give you a chance to get your debt under control and get creditors and collectors off your back (and out of your bank account).

And you wouldn’t be the first person to seek relief from financial burdens. The Bankruptcy Act of 1898 first introduced the concept of debtor relief to modern society in the United States. The modern Bankruptcy Code is based on the Bankruptcy Reform Act of 1978, which established Chapter 11 and Chapter 13 bankruptcies (more on that later).

Types of Bankruptcy

Individuals and couples can file one of two types of bankruptcy.

Chapter 7 Bankruptcy

Chapter 7 is the most common and is often referred to as liquidation bankruptcy. It’s for individuals who can prove they don’t have the income or means to pay off debts.

Filing for bankruptcy doesn’t mean you’ll lose everything you own. In fact, in most Chapter 7 bankruptcy cases, most of what is considered “reasonably necessary” to live and work is considered exempt. In many cases that can include your car and primary home.

Your 401(k), 403(b) and 457(b) plans are all considered protected assets, which means you do not have to use any of the money in those accounts to settle your bankruptcy debts.

However, if you’re way behind on your mortgage payments or already in the process of foreclosure, you could potentially lose your home. Or if you own a car that’s worth significant money (think $15,000 or more), the trustee might sell it to pay down your debt. The rules and exemptions vary from state to state.

There is no debt limit for Chapter 7, but your “means” to pay off your debt will be tested, and anyone who files for it is required to take credit counseling courses within six months of filing.

Most people can expect the process to take anywhere from three to six months.

Chapter 13 Bankruptcy

Chapter 13 — or “wage-earner bankruptcy” — is for people whose income makes them ineligible for Chapter 7. Individuals and families who file Chapter 13 will work with a trustee to restructure and reorganize their debt and pay it back over three to five years. During this time frame, debtors are not allowed to take on any additional debt.

You won’t have to liquidate any assets in Chapter 13, meaning you can keep your house. Instead, your payment plan will be determined by your household income and how it compares to your state’s median income.

Chapter 13 bankruptcy does come with some debt limits. According to the Federal Judiciary, you can only have:

• $1,184,200 in secured debt, i.e., debt that is secured by collateral, like a house or car.
• $394,725 in unsecured debt.

Federal law requires you to make your first payment to your trustee 30 days after filing.

Other Types of Bankruptcy

The Federal Judiciary describes bankruptcy as it applies to businesses and less common types of bankruptcies. Here’s a basic overview:

Type	Typically Used by	Basic Requirements	Debt Limit	Filing Fee*
Chapter 7	Individuals	Prove you don't have the means to repay debts	n/a	$335
Chapter 13	Individuals	Have reliable income and the ability to repay debts	$465, 275 unsecured; $1,395,875 secured	$310
Chapter 11	Businesses	Be engaged in commercial or business activities	n/a	$1,738
Chapter 9	Municipalities, including cities, counties and school districts	Municipality must be insolvent	n/a	$1,717
Chapter 12	Family farmers and fisherman	Individual or married couple whose primary income and debt are related to the farming or fishing operation	$465,275 unsecured;$1,395,875 secured	$313
Chapter 15	Foreign debtors	Case must involve parties outside of the U.S.	n/a	$2,309

*Debt limit, fees and requirements are accurate as of August 2024.

What Happens When You File for Bankruptcy 

The process is extremely complex, so don’t expect to go through it alone — and don’t expect it to be cheap. If you’re filing for Chapter 7 or Chapter 13, you’ll need to  complete credit counseling from an approved agency first. For all forms of bankruptcy, you’ll want to start by gathering documentation of key financial documents such as tax returns, bank statements, credit card statements, lists of assets and debts. 

Next, you’ll determine which chapter to file for based on your status (individual, couple or business) and debts. Then, you’ll file the petition with the bankruptcy court in your federal judicial district. There’s at least one in every state. The process is pretty involved, and you’ll want to consult with a bankruptcy attorney to make decisions for your individual case. As for fees, you can apply to have Chapter 7 fees waived (with this form) or set up a payment plan for Chapter 13 fees if you can’t afford them upfront. To be eligible for a waiver, your household income should be less than 150% of the poverty line (calculated for you here), and you have to be unable to pay the fee in installments.

Additionally, you’ll be responsible for legal fees, which will vary — but a few thousand dollars is not uncommon.

In most cases, this administrative process is carried out by a trustee appointed to your case.

The trustee helps you file paperwork and oversees your assets as well as the repayment plan, if applicable, during the case. They’re an impartial player who can challenge creditors’ claims or yours, based on conversations with both. 

Then a bankruptcy judge decides whether to discharge your debts. The judge could deny you for a few reasons:

• Failing to keep or produce adequate financial records.
• You failed to explain any loss of assets.
• Committing a crime, e.g., perjury.
• You failed to obey a lawful order of the bankruptcy court.
• You hid property that should have been included in your assets.

But in general, if you’re able to show your inability to repay debts, you should be granted a discharge. For Chapter 7 filings, debts are discharged within a few months after the liquidation of non-exempt assets. With Chapter 13, debts are discharged after the repayment plan is completed, which could take three to five years. 

If they rule in your favor, you’re released from personal responsibility for your debts, and creditors can’t take any more action to collect them.

Remember: Bankruptcy (Almost) Never Discharges These Debts

Debtors typically use bankruptcy to discharge credit card or medical debt. But many types of debt can’t be discharged, including:

• Student loan debt (except sometimes)
• Child support
• Alimony
• Most tax debts
• Debt you owe someone as a result of a criminal or civil charge, e.g., injury caused by a DUI

For auto loans, your debt may be discharged, but it could mean the creditor can seize the property you took a loan against — they could repossess your car, for example.

You can instead choose to “reaffirm” the debt, or leave it out of the bankruptcy discharge, and you’ll remain responsible for paying it off. And you get to keep your property.

Immediate effects on assets, debts and financial status

Assets

With Chapter 7 bankruptcy, your non-exempt assets may be sold by the trustee to pay back creditors. Non-exempt assets may be retained. For Chapter 13 bankruptcy, you can retain your assets due to the repayment plan based on your income and expenses. A Chapter 11 bankruptcy generally allows the debtor to retain their assets, but they may be sold to pay off debts. 

Debts

Once you file bankruptcy, creditors and collectors have to stop trying to collect the money you owe them while the case is open. This is called an “automatic stay.”

If a company continues to try to collect during the stay, it’s violating a court order. Let the company know in writing, and the collections will likely stop. If they don’t, notify the bankruptcy court, which can punish the company for violating a court order.

As for unsecured debts, they are either discharged (Chapter 11) or repaid through a repayment plan (Chapter 13). 

What Does Bankruptcy Do? 

Bankruptcy will be a black mark on your credit history — one that lasts up to 10 years. The immediate impact is typically a significant drop, as the filing will be on your credit report. This will make it difficult to secure new credit in the future, especially credit with attractive interest rates or terms. 

But if you’re in over your head with debt, your credit is probably already pretty marred.

Some experts say bankruptcy won’t hurt your credit much more than a poor payment history. Just make sure filing bankruptcy is really your best option, because the aftermath is not fun.

Here’s one woman’s story of what it feels like to declare bankruptcy and how she repaired her credit afterward.

Pros and Cons of Filing for Bankruptcy 

If you’re considering filing for bankruptcy, take note of the pros and cons to help guide your decision:

Pros

• A fresh financial start
• Relief from aggressive credit collections
• Potential protection from repossession of assets
• Reduced stress due to discharged debts and automatic stay

Cons

• Immediate and long-term effects on credit score
• Limitations on future borrowing opportunities
• Potential loss of assets due to liquidation
• Time, effort and fees involved with bankruptcy process

Alternatives to Bankruptcy

The following alternatives to bankruptcy can provide relief from debt while avoiding some of the negative consequences of filing for bankruptcy.

Debt consolidation

With debt consolidation, you can combine multiple debts from different creditors into a single loan or credit line, typically with a lower interest rate. 

Pros

• Simplified payments
• Lower interest rats
• Easier to make on-time payments

Cons

• Can be a temporary relief if you can’t manage the payments
• Requires a good enough credit score to achieve lower interest rates
• May include fees for loans

Debt settlement

With debt settlement, you negotiate with creditors to play a lump sum or a reduced amount of your total debts. People often use a debt settlement agency to help with this process.

Pros

• Relief from debts
• Reduced interest paid

Cons

• Impact on credit score
• May have tax implications

Credit counseling

Working with a certified credit counselor can help you develop a budget, stick to it and improve your financial health. 

Pros

• Budgeting support
• Creation of debt management lan
• Low or no cost services available

Cons

• Participation in a debt management plan can be noted on your credit report.
• May not work for more serious debt situations

How to Avoid Bankruptcy

Besides pursuing debt consolidation, debt settlement and credit counseling, how can you avoid bankruptcy? Here are some best practices when improving your financial wellness:

• Monitor expenses so you understand where your money is going. 
• Cut back on discretionary expenses like dining out, subscriptions and shopping. 
• Build and manage a budget. 
• Shop discounts, sales and deals on must-have products. 
• Set up payment plans with creditors and negotiate for lower interest rates on loans where possible.
• Pay off high interest debt first. 
• Build an emergency savings fund to avoid needing loans or credit in terms of unexpected expenses. 

FAQs About Bankruptcy

Dana Miranda is a former writer and editor at The Penny Hoarder. 

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