Bankruptcy May Not Be the Final Answer

Foreclosures and excessive debts are a homeowner's worst nightmares come true. Many believe bankruptcy to be the perfect solution for these problems. But, that's where people get trapped. Bankruptcy stays on your credit record for quite a long time, making advancing in life incredibly difficult. In addition, the updated bankruptcy law, passed in 2005, includes severe restrictions that make it more complicated to file for bankruptcy.

Nevertheless, the numbers of people filing for bankruptcies are substantial. According to data collected from the United States courts, bankruptcy filings increased slightly in the 12-month period ending Dec. 31, 2019, compared to the previous year. A total of 774, 940 people filed for personal bankruptcy, up from 773,418 in 2018. A total of 483,988 Chapter 7 bankruptcies were filed, and 283,413 were of the Chapter 13 variety.

This article is meant for people that are thinking of filing for bankruptcy and needing information regarding the process and its consequences.

Filing for Bankruptcy

When faced with foreclosure or any financial insolvency, the final option should be bankruptcy. Declaring yourself bankrupt is the only legal way to get rid of your financial setbacks. However, the process of filing for bankruptcy can be a complex and costly matter.

Key Takeaways

  • Bankruptcy is often the final option for people facing foreclosure or other financial insolvency.
  • Declaring bankruptcy is the only way to legally get rid of debts without repayment.
  • Chapter 7 bankruptcy allows individuals to discharge unsecured debt while keeping exempt assets.
  • Chapter 13 bankruptcy is often the choice for individuals seeking to hold on to non-exempt assets or seeking to delay collection efforts like foreclosures.
  • Bankruptcies can make it harder to get loans in the future, as the information stays on a credit report for up to 10 years.

When an individual files for bankruptcy, they must explain to the presiding bankruptcy trustee or judge why and how they fell into financial rut. In the meantime, the bankruptcy court will ask the individual to file their entire list of assets and outstanding debts.

Assets are divided into two categories according to their nature:

  • Exempt Assets: These assets cannot be realized to pay the debts. Examples include some part of the equity in your home and automobile, personal items, clothing, pensions, tools needed for your employment, social security, and any other public benefits.
  • Non-Exempt Assets: As the name suggests, these assets can be seized and sold to repay outstanding accounts. Property (other than the primary residence), recreational vehicles, boats, a second car or truck, collectibles or other valuable items, bank accounts, and investment accounts.

Classifying Outstanding Debt

Likewise, outstanding debts are classified into two types:

  • Secured Debts: These include loans in which the creditor has a security interest in the property provided as collateral. Mortgages and car loans are the most common types of secured loans.
  • Unsecured Debts: These debts are not secured by the property or other collateral. Examples include credit card debt, medical bills, and personal unsecured loans.

The bankruptcy court considers secured debt as critically important because its non-payment will compel the creditor to lay claim on the property chosen as collateral.

Once all the essential information has been filed with the court, a bankruptcy trustee is designated to make sure that secured debt is repaid in the given period. Consequently, the court issues a mandatory stay that prevents creditors from laying their hands on assets through property confiscation or foreclosure. The stay also prevents the creditors from pursuing a lawsuit to collect money owed.

Chapter 7 vs. Chapter 13

A person, depending on their circumstances, can file either Chapter 7 or Chapter 13 under bankruptcy law:

Chapter 7: This liquidation option enables the individual to keep exempted assets, whereas unsecured debts are discharged. Here, the non-exempt assets are sold or realized to repay the secured debts. However, debts like student loans, child support, and taxes will not be dismissed. Chapter 7 is generally chosen by individuals with lower income, few assets, and more overall debt.

Chapter 13Under this reorganization proceeding, debts are repaid over a specified period of three to five years through a logical repayment plan. The trustee collects the payments and transfers them to creditors. Here again, the individual is permitted to keep their home, thereby preventing any looming foreclosure. Chapter 13 bankruptcy option is normally preferred by individuals who are interested in keeping their non-exempt property intact or who want to buy time against foreclosures or property seizures.

Effects of the 2005 Law

The Bankruptcy Abuse Prevention and Consumer Protection Act was implemented in 2005 and made big changes to the country's bankruptcy laws. With the implementation of the updated 2005 bankruptcy laws, people are, to a greater extent, compelled to file for Chapter 13 instead of Chapter 7.

In order to be eligible for Chapter 7, present monthly income would be calculated against the average income for a family of your size in your state. Here, the present monthly income is based on average income over the last six-month period. If your income is less than or equal to your state's average income, then you will be eligible to file under Chapter 7. However, if your income is higher, then you must pass a "means test" to meet the criteria for Chapter 7.

Means Test

In a means test, disposable income is calculated by subtracting from present monthly income the specific expenses set by the Internal Revenue Services (IRS) and secured debt payments. Now, if monthly disposable income after deducting the above amounts is less than $100, Chapter 7 is allowed.

If disposable monthly income is between $100 and $166.66, then it is multiplied by 60 to determine whether enough money is left to pay more than 25% of non-secured debt over a period of five years (60 months). If yes, Chapter 13 is preferred over Chapter 7. If no, Chapter 7 is probably the option. However, the court has the authority to force Chapter 13 if it realizes that the individual is misusing the system by filing for Chapter 7.

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As stated by the 2005 law, the court abides by the living standards set by the Internal Revenue Service. This implies that the court decides what amount is reasonable to pay for daily expenses (food and rent) and then how much should remain to pay for the debts.

The new law places stringent restrictions on exemptions in a way that homeowner's may not be permitted to keep all or a large part of the equity in their home. Consult your bankruptcy attorney to get more information about this issue.

Finally, the new law directs that individuals should meet with a credit counselor in the six months before applying for bankruptcy and also attend a money management program before debts are paid off.

The Debt Discharge

When the court issues a discharge, the debtor is then relieved of any liability to pay back their debts. That means creditors no longer have a legal claim against the debts, so they cannot pursue any collection activity, take any legal action, or communicate with the debtor in any way.

The court sends creditors a notice that the debts have been discharged. A copy is also sent to the petitioner's lawyer as well as the U.S. Trustee within the Department of Justice. Any creditor who attempts to collect a debt after receiving a notice of discharge can be fined.  

For a Chapter 7 bankruptcy, the discharge is usually issued anywhere between four and six months after the bankruptcy petition is filed. The discharge under Chapter 13 bankruptcy is issued after the payment plan is complete, usually three to five years after the bankruptcy filing. 

Pros and Cons of Bankruptcy

One main point to consider is that you can avail of a bankruptcy loan after all your debts have been repaid and the bankruptcy has been dismissed. The main purpose of this loan is to restore your worsened financial health back to normal.

The negative point is that bankruptcy can stay on your credit report for more than 10 years, depending on which chapter you've filed. The cost of having a bankruptcy stamp on your credit score will affect your future prospects of getting a mortgage, personal loan, or a credit card.

7 to 10 Years

Bankruptcies stay on credit reports for a long time: seven years for completed Chapter 13 bankruptcies and 10 years for Chapter 7 bankruptcies.

After waiting for some time, individuals that have filed for bankruptcy can try to get back into the credit game by applying for secured credit cards, using them only when needed, and making payments regularly and on time. This step can help rebuild credit and improve overall financial health. 

The Bottom Line

Declaring bankruptcy is usually not the key to ending money problems. The odds may work out against you, with bad credit in your name. In addition, filing for bankruptcy has become more complex as well as costly because of the 2005 bankruptcy laws. As such, consultation with a trustworthy bankruptcy attorney before filing is sometimes the best approach. Ultimately, making the right move in the right situation can provide you with a needed respite from anxiety and debt.