Who goes bankrupt? What does it mean to declare bankruptcy? And what are the consequences? Karen Carr, CFP®, tackles this toughest of financial topics.
For many of us, our closest understanding of bankruptcy comes from playing Monopoly or watching Wheel of Fortune. It’s a term that gets bandied about often in the news, but it can be hard to discern the exact intricacies of it. Who goes bankrupt? And what does it mean? What are the consequences? Even if it’s not a remote possibility as far as you’re concerned, it can still be helpful to know what bankruptcy is and why people file for it. Below we’ve answered five common questions about bankruptcy.
1. What Does Bankruptcy Mean, Exactly? In a nutshell, bankruptcy means you don’t have enough money to pay your debts. It is a legal term that applies to people who formally declare bankruptcy via the court system. In the U.S., either individual citizens or businesses can declare bankruptcy, although the requirements and proceedings are different for each. Usually, it is the person or business that is in debt who files for bankruptcy (rather than the creditor forcing them into it.)
There are two major types of bankruptcy for individuals:
- Chapter 7: Also known as “liquidation,” this is when some of your assets may be sold to repay all or part of your debt. Once this has happened, you no longer owe any more money, even if the debts weren’t repaid in full. It’s available to both individuals and businesses.
- Chapter 13: This is a reorganization of your debt into a repayment schedule over three to five years. You’ll have to repay from 10% to 100% of what you owe, depending on your income, type of debt and how much you owe.
The major difference between the two is that with Chapter 7 you will have to liquidate some of your assets. With Chapter 13, you keep your assets, but you must repay at least a portion of your debt. If you want more detail on the types of bankruptcy, here are some resources.
You may also have heard of Chapter 11 bankruptcy, which applies to businesses only.
2. What Are the Steps Needed to Declare Bankruptcy? To declare bankruptcy as an individual, you must first file a federal petition. Depending on what type of bankruptcy you file for, the next steps will vary. If you file for Chapter 7, then all of your assets will be reviewed by the court system to determine if they have any value. Assets could include your home, car, valuables, retirement accounts, stocks and more. These may be “liquidated” to pay back at least a portion of your debt.
If you file for Chapter 13, the court will determine a “reasonable” repayment schedule and set up monthly payments that will take three to five years. Ultimately, you may have to pay back 100 percent, or it may be less.
3. What Are the Consequences of Bankruptcy? The short-term consequences of bankruptcy depend on the type of bankruptcy you decide to declare, but could include the liquidation of some of your assets and/or a repayment schedule.
Here’s the bad news: Bankruptcy will hurt your credit. There’s pretty much no way around that, since it will stay on your credit report for as many as 10 years. Yikes. However, it’s not permanent. If you find yourself in a position where declaring bankruptcy is the only financial option for you, it’s important to focus on the future. Pay your bills on time every time. You can check your credit score as often as you like using sites such as Credit Karma. I recommend checking it a few times a year. Recognize that it will take time to rebuild and will probably never be perfect, but you can still move forward if you focus diligently on keeping your finances in the black.
You should also note that, in most cases, student loans are not discharged when you declare bankruptcy.
4. Is It Ever a Good Idea to Declare Bankruptcy? It’s certainly not ideal, but when you have no means to pay your debts, bankruptcy may become inevitable. Of course, you shouldn’t look at bankruptcy as a “get out of jail free card,” which is how it’s sometimes portrayed in the media. In reality, you will likely have to pay back a large chunk of your debt over time. Declaring bankruptcy gives you some breathing room and may allow you to avoid paying your debts in full if it’s truly not possible for you, but it’s not a quick fix and it does have consequences, as we described above.
5. How Do People Recover from Bankruptcy? Slow and steady is the answer here. As I mentioned above, it will hurt your credit score, but, if you focus on paying your bills on time going forward, you will eventually rebuild your credit. Once you have settled the debts you owe, if you can avoid going into considerable debt in the future and keep yourself above water, you will recover. Here are some tips on how to pay off debt on a small income, and here’s a story about grownups who survived financial disaster of a different sort (foreclosure). It’s not an easy road, but many people have walked it and it can be done.
This story was first published on Kiplinger.com.
Karen Brady is the founder of Simplie, a financial planning company that offers virtual appointments with CERTIFIED FINANCIAL PLANNER™ professionals. Karen is a former member of the Society of Grownups planning team and is now based in New York City. When she’s not writing about personal finance or meeting with clients, you can find her roaming around NYC looking for the best place to eat.