Personal Bankruptcy

Personal bankruptcy is a process in which an individual with significant financial debts officially declares they are unable to pay those debts. After filing with a bankruptcy court and either liquidating assets to pay creditors or completing a payment plan over several years, the individual receives a discharge, an official court order stipulating that they can no longer required to pay the eligible outstanding debts.

In the United States, the federal government allows individuals to file for one of two types of bankruptcy: Chapter 7 and Chapter 13. These two forms of bankruptcy have different rules and apply to different financial situations. Bankruptcy is heavily regulated in the United States, and individuals who declare bankruptcy are required to adhere to strict rules and also complete mandatory credit and financial counseling. Although some may view the process as a relatively easy means of escaping one’s debts, personal bankruptcy actually has significant and long-lasting financial ramifications for the debtor, and the decision to declare bankruptcy should not be made lightly.

Background

For as long as human beings have loaned money to one another, there have been people unable to pay their debts. Bankruptcy, as a financial and legal process, has been a fixture of Western society since at least the sixteenth century, and the first British law concerning the practice was introduced in 1542. The United States has had bankruptcy laws for much of its history; the first such law, based on the later, less harsh incarnations of British bankruptcy law, was introduced in 1800 but repealed three years later. Bankruptcy laws returned in various forms over the next centuries—though the first permanent federal law was not enacted until 1898—and became of particular concern during the 1930s, when the Great Depression forced many Americans into extreme poverty. The Bankruptcy Reform Act of 1978 introduced major reforms to bankruptcy law, while the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ushered in further reforms, introducing new regulations to prevent unscrupulous debtors from abusing the system. Among the reforms introduced by the 2005 law were the requirement that those seeking bankruptcy complete credit counseling and the requirement for a means test determining eligibility for liquidation-based bankruptcy.

Generally regarded as an extreme measure, bankruptcy is typically thought of as a last resort for individuals mired in debt that they have no hope of ever repaying. In many cases, an individual’s required debt payments may exceed their monthly income. Often, those who choose to declare bankruptcy have attempted to make payments and work with creditors to establish payment plans but have been unable to do so. Among the types of debt that prompt debtors to consider bankruptcy are mortgages and credit card debt. However, medical debt was the most common cause of bankruptcy by the early twenty-first century.

There are some drawbacks to bankruptcy, and individuals considering filing must be sure to be aware of and weigh all of the factors involved. Perhaps the most significant factor is that certain types of debt cannot be discharged through bankruptcy proceedings, and debtors who file for bankruptcy will remain responsible for them. Such debts include child support payments, some delinquent income taxes and government fines, and most student loans (though some changes to discharging student loan debt through Chapter 13 bankruptcy were made in the mid-2020s, making discharge of this type of debt more attainable). In addition, bankruptcy has serious and long-lasting financial ramifications, appearing as a major derogatory mark on an individual’s credit report for as many as ten years. The poor credit score resulting from bankruptcy could make it very difficult for the individual in question to obtain loans or credit cards in the future. Finally, there are several procedural requirements of bankruptcy that some individuals may consider significant drawbacks. Filing is not free. The federal government sets the filing fee depending on the type of bankruptcy for which the individual files. Additional fees, such as for legal assistance, which may range from $750 to $4,500, or the required credit counseling, ranging from $50 to $250, could likewise complicate the situation for debtors considering bankruptcy. In total, most individuals spend $1,300 or more to file bankruptcy.

Overview

Filing for personal bankruptcy is a relatively complex process subject to numerous state and federal regulations. As such, the process should be carried out with great care. Individuals planning to file for bankruptcy should consider consulting a lawyer or government agency to ensure that they meet all requirements and will not face further difficulties at a later date.

Having determined that bankruptcy is the best or only solution to one’s debt problems, one must begin the process of declaring bankruptcy by making an appointment with a government-approved credit counselor, as mandated by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Counseling must be completed within 180 days before the individual’s filing date. During the counseling process, a counselor will review the individual’s finances, discuss potential solutions other than bankruptcy, and help the individual set a budget. After counseling is completed, the counseling agency will issue the debtor a certificate proving that they completed this required step.

Next, the individual must choose which form of bankruptcy they wish to file under, based on their legal eligibility, assets, and debts. To begin the legal bankruptcy process, one must complete paperwork listing all debts, creditors, and assets as well as supplying information about one’s income and file the forms with the bankruptcy court in one’s judicial district. The debtor will typically meet with creditors and sometimes court officials but usually will not be required to appear before a judge unless objecting to some aspect of the proceedings. Depending on the form of bankruptcy they have chosen, the individual will be required either to forfeit property to be liquidated or design and gain approval of a payment plan, which will be used to repay a portion of their debts. In addition to completing one of those processes, the individual must complete an approved debtor education course that teaches financial management skills that they will ideally use to avoid filing for bankruptcy again in the future. Once that is completed and the court has approved the bankruptcy, the individual’s eligible debts are discharged and they are no longer responsible for making payments.

While US bankruptcy law allows for six different types of bankruptcy, only two are available to individuals: Chapter 7 and Chapter 13. Chapter 7 bankruptcy requires that the debtor’s nonexempt assets be liquidated by a trustee appointed by the court and the proceeds divided among the debtor’s creditors. Assets to be liquidated do not include property deemed exempt by the debtor’s state, which typically includes property that is worth less than a defined monetary value. Chapter 7 bankruptcy is available only to individuals who pass the means test put in place by the 2005 bankruptcy law, which determines, based on income, whether an individual is eligible. An individual is eligible to file for Chapter 7 bankruptcy if their household’s monthly income is less than the median income for a household of that size in their state. An individual with income higher than the median may also qualify if their monthly disposable income—income remaining after certain expenses—is less than a defined amount.

Those who do not qualify for Chapter 7 bankruptcy due to their income may typically file for Chapter 13 bankruptcy, intended primarily for individuals with steady income. Unlike Chapter 7 bankruptcy, Chapter 13 allows debtors to keep rather than liquidate many of their assets. An individual filing for this form of bankruptcy must develop a payment plan based on their projected future income and make payments per that plan for the next three to five years. After that time, their remaining eligible debts are discharged.

Because of the long-lasting ramifications of bankruptcy, many people attempt to avoid it by taking steps to improve their financial situations before such a drastic measure is needed. Crucial steps include reducing spending, avoiding taking out any further debt, and increasing income, either through obtaining a new or additional job or liquidating assets such as valuable personal property and real estate. Some individuals with significant debt can negotiate with their lenders and establish payment plans that make repayment less difficult. Loan consolidation, a process in which an individual takes out a new loan and uses the funds to pay off multiple existing loans, can also be helpful, as it reduces the individual’s regular debt payments. While this strategy does present some risks, it can be helpful for some individuals if managed responsibly.

Credit counseling is also frequently helpful in preventing bankruptcy, as the federal requirement that individuals complete the process prior to filing indicates. Credit counselors can advise individuals on what steps to take, help them budget, and generally improve their financial literacy. However, all individuals considering visiting a credit counselor must be sure to research counselors carefully and work only with legitimate organizations, as unscrupulous credit repair companies have been known to mislead desperate clients and use fraudulent tactics that could easily make one’s financial situation significantly worse.

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