What Is Bankruptcy, and How Does It Work?

What Is Bankruptcy, and How Does It Work?

by: Maurie Backman |  Feb. 21, 2020

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When you're drowning in debt with no end in sight, you may start wondering if you should file for bankruptcy. There are both benefits and drawbacks to taking this drastic step, so it's important to know what you're signing up for. Here, we'll discuss how bankruptcies work and help you decide if it's the right route for you to take.

What is bankruptcy?

Bankruptcy is a legal process that lets people or entities who can't pay their debts obtain some type of relief by having those debts either reorganized or eliminated. You can file for bankruptcy as an individual, a corporation, or a municipality.

How do bankruptcies work?

When you file for bankruptcy, your debts are either reorganized so they're easier to pay off, or wiped out so you don't need to pay some or all of them. The exact process depends on the chapter of bankruptcy you file for.

When should I declare bankruptcy?

You might consider filing for bankruptcy when your debts are such that you see no reasonable way to keep up with your payments. The purpose of bankruptcy is to give people (or companies or municipalities) a chance either to wipe out some of their financial obligations and start over with a clean slate, or to repay those obligations in a more affordable fashion.

However, to be clear, bankruptcy is not an option to consider if your debt is fairly new, or if you're going through a temporary financial crisis that's likely to improve (such as being out of a job). There are consequences associated with filing for bankruptcy, and it's most certainly not a "get out of jail free" card. So you should really consider bankruptcy only as a last resort if you've tried paying off your debts but keep digging yourself deeper into a hole.

Types of bankruptcy

Bankruptcy isn't a one-size-fits-all solution. There are different chapters of bankruptcy that apply in different circumstances. If you're filing for a personal bankruptcy, your choices are Chapter 7 and Chapter 13.

Chapter 7 bankruptcy

Chapter 7 is a personal liquidation bankruptcy. Your non-exempt assets are sold off by a court-appointed trustee to pay your debts to the greatest extent possible, and from there, your remaining unsecured debts are eliminated. (The amount of assets you can exempt varies from state to state.) Unsecured debts are those without collateral behind them -- debts like credit card balances and medical bills.

Qualifying for Chapter 7 is harder than qualifying for Chapter 13 because you'll be subject to what's known as the means test. If your income is lower than the median income in your state for a household your size (meaning, based on the number of dependents you have), you'll pass the means test and be eligible for Chapter 7. If you don't pass the means test based on income alone, you can deduct certain expenses, such as taxes, mortgage payments, and child care, from your income to see if it comes in under the necessary threshold.

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