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There’s nothing more disheartening than the feeling that you’re in a financial hole from which you can’t dig yourself out. When it becomes clear that – even with extreme measures – you won’t be able to get caught up on overdue bills, it may be time to make a fresh start.

For many Americans, that means filing for a Chapter 7 bankruptcy. When individuals submit a petition using this section of the bankruptcy code, an “automatic stay” is put into effect, forbidding businesses from threatening a lawsuit against them or even trying to collect on the debt. A court-appointed trustee will look over the debtor’s financial information and may sell some of his or her unprotected assets to pay off creditors. Under normal circumstances, the end result is a discharge from any debts included in the filing, even if the sale proceeds fall short of the amount due.

While it may seem like a relief to wipe your slate clean of old debts, it’s worth remembering that there are trade-offs. Chapter 7 bankruptcies put a big dent in your FICO score and remain on your credit report for 10 years. Even if you work hard to rebuild your credit, it could be a while before you qualify for certain loans or obtain favorable interest rates.

What Happens to My Property?

One of the biggest worries among those considering a Chapter 7, or liquidation, bankruptcy is the fate of their most cherished possessions. Just because your assets have resale value, it doesn’t necessarily mean the trustee will put them on the market. The federal bankruptcy code has exemptions that protect certain assets, although most states require the filer to use the state's own allowance schedule, rather than have the option to use the federal list. For example, Virginia allows you to keep your car if you have less than $6,000 in equity, or $10,000 you use the vehicle for work or school.

If you’re current on your mortgage – or can catch up on your payments in short order – you may also be able to keep your house. A provision known as the homestead exemption allows borrowers to protect a specific amount of equity in the home. Here, too, the number can vary from state to state. If you have $75,000 in equity, but the exemption in your state only protects $50,000, the trustee may put the home on sale to help reimburse other creditors.

If you have too much equity in property – or you’re significantly behind on payments – your attorney may suggest the Chapter 13 form of bankruptcy instead. Unlike Chapter 7 filings, this version involves a reorganization of one’s debts in which the borrower creates a plan to pay down all or part of their “past due” balance over three to five years. In some cases, this is the only way to keep one’s home, although it requires sufficient income to keep up with a repayment plan – a luxury not every filer has. See The Other Personal Bankruptcy Option: Chapter 13.

In some cases, a creditor with a lien against your property – as in the case of a car loan – may require you to “reaffirm” the loan if you wish to keep it. A reaffirmation is an agreement saying you’ll continue to make payments and exclude the debt from the bankruptcy proceeding. In exchange, the lender pledges not to repossess the property as long as you stay current on the loan.

Homes are one exception to this rule. While it may be a good idea to reaffirm your mortgage, mortgage lenders generally don’t require it. And the bank can’t foreclose if you continue to make timely payments, even if you never reaffirmed the loan.

Eligibility

Debtors can file for liquidation bankruptcy individually or, if they’re married, jointly. There are some exceptions, however. If you make more than the median income level in your state, a filer has to pass a “means test.” The goal of this is to ensure that only those who truly can’t pay their debts benefit from bankruptcy protection. If you have to undergo the means test, the court will look at your monthly disposable income and determine whether you can afford to pay some of your overdue loan amounts. If so, a Chapter 13 reorganization may be your only choice.

Additionally, debtors cannot seek protection if they filed (and received a discharge) for Chapter 7 bankruptcy within the past eight years or Chapter 13 within six years.

As long as they meet these requirements, even borrowers who operate a business as a sole proprietorship may take advantage of Chapter 7. This decision can be tricky if the owner wants to continue operations because the assets of the business, in this case, are the legal responsibility of the individual. Therefore, the trustee may choose to sell non-exempt property, even if it’s used strictly for business needs. A competent attorney will be able to look at your unique circumstances and advise whether a Chapter 11 bankruptcy – a reorganization plan for businesses – makes more sense. See What Are The Differences Between Chapter 7 And Chapter 11 Bankruptcy?

A partnership may also submit a Chapter 7 petition, although the fallout is more complicated if the other owners are personally liable for some of the debt in question. Further, the partnership is dissolved once the liquidation occurs.

The Bottom Line

Chapter 7 bankruptcy provides a nearly clean slate for those who genuinely cannot catch up on their loan payments. If you want to keep certain property, such as a home or car, be sure to ask your bankruptcy attorney whether filing will put them at risk in your case.

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