If you get too deep in debt, your income collapses, or you experience a major life crisis, you may need to consider bankruptcy.
It’s a difficult process, but it may be completely necessary if you see no way out of your current debt problems.
There will be credit issues to deal with after the fact, but it may be more important to get out from under the immediate crisis and work through the credit fallout later.
Types of Bankruptcy
More than anything else, Bankruptcy is intended to be a fresh start. Sometimes that’s exactly what you need.
There are three primary types of bankruptcy that apply to individuals.
Each is structured differently and has its own nuances. Let’s discuss all three.
What is Chapter 7 Bankruptcy?
Chapter 7 bankruptcy is sometimes referred to as total bankruptcy.
That’s because all your debts are legally eliminated upon the discharge of the bankruptcy proceeding. In most cases, you’ll work with a bankruptcy attorney who will file the necessary paperwork with the court.
After a period of several months, the discharge will be issued.
As soon as you file for Chapter 7, most creditors will be immediately prevented from taking further collection action.
That means they won’t be able to put a lien on your house, seize your bank account or garnish your wages.
If that sounds too simple, it’s because it is.
Chapter 7 bankruptcy is also referred to as liquidation bankruptcy because the court-appointed trustee can seize any assets you have in partial repayment of your creditors.
So while you may get out of debt in just a few months, you may give up substantial assets in the process.
However, each state exempts a certain dollar value of specific assets from bankruptcy liquidation. Exactly which property can be exempt, and in what amount, depends on the laws in your state.
For example, California exemptions allow you to retain up to $75,000 in owner-occupied real estate equity if you’re single, and up to $150,000 for families.
The exemptions are higher if you’re a senior citizen or disabled. You can also exempt automobile equity up to $1,900, and up to $2,000 in bank deposits from Social Security.
Employer sponsored retirement plans are typically exempt, and most states also shield individual retirement accounts as well.
Any amounts you have in excess of state exemption limits can be seized by the court and used to pay your debtors. This can include second homes, investment property, and taxable investment accounts, among other assets.
Filing for Chapter 7 Bankruptcy
When you file, there will be certain fees. These will include filing and administrative fees, as well as attorney fees.
These can range from a few hundred dollars to a few thousand dollars, depending on the complexity of your case. You’ll not be able to discharge these fees in the bankruptcy.
There are limitations to Chapter 7 bankruptcy.
For example, you won’t be able to file if you previously filed for bankruptcy within the past six to eight years. Your eligibility will also be based on your ability to repay.
If you have sufficient income left over after paying your necessary living expenses, and it’s considered enough to pay off a large amount of your debt, you may be required to file Chapter 13 bankruptcy instead.
You should also be aware that bankruptcy does not discharge all debts.
Obligations such as child support, tax debts, and student loans cannot be discharged in bankruptcy unless the bankruptcy judge determines there are extenuating circumstances.
Also, if a creditor can show that you took a loan based on fraudulent information, it may be excluded from the discharge.
What is Chapter 11 Bankruptcy?
Chapter 11 bankruptcy is commonly referred to as reorganization bankruptcy.
That’s because it involves the reorganization of the debtor’s business and financial affairs, including debts and assets. It’s typically filed by corporations looking for protection from creditors, and to give them time to restructure their debts.
It’s more similar to Chapter 13, in that it doesn’t discharge the debtor’s obligations, but simply gives them time to improve their situation.
Because of the nature of Chapter 11 is more complicated than personal bankruptcy, it’s much more expensive to bring about.
The advantage to Chapter 11 is that the business can continue operating while it’s in the plan. Many large companies have used this form of bankruptcy to reorganize their debts and survived the bankruptcy intact.
To begin the process, the business will propose a reorganization plan. It may include reducing business operations and expenses, as well as renegotiating certain debts.
The business may even obtain an entirely new financing arrangement as part of the bankruptcy plan. They can also propose liquidating certain assets for payment of obligations. If the creditors are unsatisfied with that plan, they can offer an alternative plan.
In most cases, Chapter 11 is filed by corporations, partnerships and limited liability companies. However. it is available for personal bankruptcy for those who have an excessive amount of debt or don’t qualify for either Chapter 7 or 13.
The business will typically run its usual operations, however, in cases involving fraud, other criminal activity or gross incompetence, the organization may be run by a court-appointed trustee throughout the entire process.
If that happens, the business will not be able to make certain decisions without court approval. This may include the sale of assets, entering in new business arrangements, or terminating existing ones.
What is Chapter 13 Bankruptcy?
Chapter 13 is a form of bankruptcy that involves a repayment plan. The plan will be based on your available income after necessary living expenses, with the remainder going to paying your debts.
The term of the repayment is generally between three years and five years, though it’s possible to pay it off in less.
The main advantage of Chapter 13 is that you will not be forced into the liquidation of your assets. It’s generally available only to those who have a steady income, such as a regular salary.
There are also limits on the amount of debt you can owe to qualify. For example, if it’s clear you won’t be able to pay off a significant amount of debt within the five-year term, based on the income you have available, you’ll most likely be put into Chapter 7.
Chapter 13 bankruptcy does impose a hierarchy on debts. Certain debts referred to as priority claims, must be fully included in the payment plan. These include child support, alimony, and most tax debts.
Secured debts, like a mortgage or car loan, will need to be included if you want to keep those assets.
Unsecured debt will be paid out of what remains after the payment portion for priority debts and secured debts are covered.
These include credit cards, medical debts, and other unsecured obligations. It isn’t even necessary that you’ll be able to pay off the entire unsecured balances, or even any at all.
Though you’ll be able to protect most of your assets from the liquidation using Chapter 13, it will generally require several years of making monthly payments.
And as long as you’re in the payment plan, it will be more difficult to secure new credit going forward.
How Long Does a Bankruptcy Stay on Your Credit Report?
According to myFICO.com, a bankruptcy will remain on your credit report for seven years after the completion of a Chapter 13, and 10 years after the completion of Chapter 7.
That may seem like a long time, but the impact of the entry on your credit report will decline over time. Certainly, the greatest negative impact will be within the first two years.
But after that, your credit score should begin to improve – as long as you begin taking new credit and making your payments on time.
As each year passes, your credit score should improve a little bit more – even though the bankruptcy is still showing on the report.
For example, the negative impact will be less five years after discharge than it will be after two years. When it comes to bankruptcy and your credit report, patience truly is a virtue.
Just be aware that there are some creditors that have a “no bankruptcy” policy. Even if your bankruptcy was discharged several years ago, and your credit score has improved significantly, they may still decline your application.
Wherever possible, you should determine if a lender has this policy before making an application.
Removing a Bankruptcy From Your Credit Report
Since a bankruptcy appears on your credit report as a public record (from the court), the only way to remove it from your credit report is to wait until the necessary seven or 10 years have passed.
If you’re approached by a credit repair company that claims they can remove it from your report, it’s a bogus company.
The only time a bankruptcy entry can be removed from your credit report is if it appears in error. That’s a possibility if you have a common name, like John Smith, or if someone in your family with the same name filed for bankruptcy.
If that happens, you’ll need to contact each of the three credit repositories – Experian, TransUnion and Equifax – and dispute the entry.
They’re required by law to investigate your claim and will remove the entry if more specific information, like your Social Security number, doesn’t match with the actual bankruptcy case.
Credit Repair After Bankruptcy
So much of the benefit of bankruptcy depends on what you do immediately after by attempting to repair your credit after bankrupcty. You’ll need to begin gradually rebuilding your credit, but be careful.
There are lenders who specifically target people coming out of bankruptcy. They do this because they know that such people are anxious to begin rebuilding their credit.
But also because they know once you file for bankruptcy, you won’t be able to do it for several more years. That will prevent you from discharging a loan from that creditor for many years.
The problem is that many of these companies are predatory. They’ll charge very high-interest rates, high fees, or a combination of both.
While you may be anxious to begin rebuilding your credit, these lenders are mostly interested in exploiting your situation for high income. Don’t fall for it, there are better ways.
Secured Credit Cards and Credit Builder Loans to the Rescue
In most cases, the best ways are to open either a secured credit card or what’s known as a credit builder loan.
There are specialized credit card lenders, as well as a very few banks and credit unions, that offer secured credit cards.
In most cases, you’ll need to open a savings account, and the amount of your credit line will be equal to the balance in the account. For example, with a $500 savings account, you’ll be issued a credit card with a $500 credit line.
There are a few specialized lenders that will even approve a credit card with a small credit line with a deposit that’s less than the credit line.
For example, you may be issued a credit limit of $200 for a deposit of $50 or $100. The downside of this type of card is that the credit limits are low, generally no more than $300. They also charge high annual fees, ranging between $75 and $100.
In either case, you’ll be issued a credit card that works like any other. Your payments will be reported to all three credit bureaus, giving you an opportunity to build new, good credit.
This will be important to offset the bankruptcy entry on your report. The more good credit you have, the higher your credit score will go.
Credit Builder Loans
A credit builder loan can be even more effective than secured credit cards, particularly if you have no money. They’re offered by many banks and credit unions – in fact, they’re becoming steadily more common across the industry.
Basically, you apply for a loan, say $1,000. Even though you have a very low credit score as a result of the bankruptcy, the bank approves the loan.
But instead of giving you the funds, they’re deposited into a savings account. The monthly payments are then automatically withdrawn from the savings account to pay the loan, guaranteeing on-time repayment. Loan terms are usually between 12 and 18 months.
Once the credit builder loan is paid, not only will you have a perfect payment history on the loan, but you’ll also have a paid loan. That’s one of the strongest credit entries you can have on a credit report. And all of that will be reported to the three credit bureaus.
If you can get two or three of these loans in place as soon as possible after your bankruptcy discharge, you’ll be able to rebuild your credit score pretty quickly.
Best of all, the whole process will take place out of sight. Since the bank will be making automatic withdrawals from the savings account to pay the loan, you won’t have to worry. In most cases, the most it’ll cost you is maybe $50 or $100 for the interest on the loan.
Bankruptcy Explanation Letter
If you do file bankruptcy, you’ll need to have a bankruptcy explanation letter prepared as soon as possible. Anytime you apply for credit – or even for a job or an apartment – you’ll need to be ready to submit that letter.
A good bankruptcy explanation letter will explain the reasons why you filed for bankruptcy. Your challenge will be to make it clear that it was the result of a one-time event, such as a job loss, business failure, divorce, or health related issue.
The letter will also need to convince the reader that you’ve overcome the problem and will be highly unlikely to be a similar credit position in the future.
With a convincing bankruptcy explanation letter and two or three good credit references on your credit report, you should begin making steady progress in rebuilding your credit going forward.