What is bankruptcy?

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Historically, the term “bankruptcy” referred to the financial status of an individual or business that is unable to repay outstanding debts to creditors. In the US today, however, bankruptcy is a process that consumers, businesses, organizations and even government entities can use to deal with debt obligations that they will not be able to satisfy.

In some cases, a bankruptcy may eliminate or discharge much (if not all) of the eligible debts owed by the bankruptcy petitioner. In other cases, the bankruptcy may also involve a payment plan that requires the bankruptcy petitioner to make restructured payments to eligible creditors and lenders.

A bankruptcy in the United States is technically a legal judgment in bankruptcy court, sometimes accompanied by a court-monitored plan, addressing the liability an individual or company has to creditors. A bankruptcy can completely discharge all debt, some of the debt or establish a repayment plan to the lenders.

As bad as bankruptcy may seem today, the alternatives practiced in the past were much worse. Prior to the notion of a legal bankruptcy, people who could not pay their debts for any they reason could be assigned work duties or could become individual slaves to a creditor until the outstanding debt had been repaid. Debtor prisons were also an answer to those who defaulted on their loans.

Bankruptcy is also a federal matter, and federal law has identified different legal pathways for various types of bankruptcy filing options. The specific process required will depend on the nature of the bankruptcy request and the type of entity entering into bankruptcy.

Types of consumer bankruptcies

There are two primary types of bankruptcy available for individuals:

  • Chapter 7 bankruptcy
  • Chapter 13 bankruptcy

The main difference between the two types of bankruptcies is that a Chapter 7 typically wipes away all the eligible debts covered in the bankruptcy judgment, while a Chapter 13 attempts to set up a debt repayment plan.

A Chapter 7 filing will release an individual from all outstanding, dischargeable debt owed. This is the simplest of the bankruptcy filings – but also the more difficult. To qualify for a Chapter 7 bankruptcy, applicants must prove that they are truly unable to pay back the debt in a realistic time period.

The individual requesting a Chapter 7 bankruptcy must first pass an income means test. The first part of this personal bankruptcy means test compares current monthly income with the median income for the state in which the person resides. If the individual’s monthly income is less than the state median, then the borrower is automatically eligible to file for Chapter 7 bankruptcy.

If the individual’s income is greater than the state median, it becomes more difficult (though not impossible) to qualify. The individual must then complete the rest of the means test to demonstrate that he or she will not have enough disposable income (after paying allowed monthly expenses).

A Chapter 13 filing is sometimes called a “wage earner” plan where a court trustee establishes a repayment plan with debts to be paid out over time to the outstanding creditors. The repayment plan follows a strict budget that is monitored by the bankruptcy court. This repayment plan is not a loan consolidation, and it can often last three to five years.

The amounts repaid in a Chapter 13 plan may not necessarily be the outstanding amounts owed to the creditors. Instead, it is often a lower amount determined by the court and the creditors.

Bankruptcy options and applications

A bankruptcy is not the solution for all debt problems.

In fact, there are certain debts that are not dischargeable with either a Chapter 7 or Chapter 13 filing. Student loans and taxes on income or property, for example, are not dischargeable with a Chapter 7 filing — but may be included in a repayment plan with court approval. Secured debts such as mortgage loans and car loans may also not be discharged, though a foreclosure, repossession or payment plan may be established.

A bankruptcy is never in a consumer’s early financial planning and is typically a result of a catastrophic event such as a sudden loss of job, divorce or an illness or death in the family. A bankruptcy filing should never be taken lightly, as it does result in considerable damage to a person’s credit report and score. However, there are times when a bankruptcy is the only way out of a seemingly hopeless financial situation.

There are even institutional and private lenders who specialize in helping those who have filed for bankruptcy reestablish their credit history. When used properly, a bankruptcy doesn’t end a consumers’ personal credit but can provide a path to recover a new, better credit history.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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