What is bankruptcy? All you need to know before you file

When you have a daunting amount of debt and are having trouble paying it back, bankruptcy is an option. Filing bankruptcy gives you a fresh start by stopping collection efforts, wage garnishments and more.

However, while filing for bankruptcy is right for some people, it also has lasting effects on your credit. Learn more about how bankruptcy works, the types of bankruptcy available and what you need to know before filing.

Key insights

• Filing bankruptcy can stop collection efforts, foreclosures and wage garnishments.
• Bankruptcy can wipe away many kinds of debt, but you may need to continue making payments.
• Court costs and attorney fees can make filing for bankruptcy a challenge for some people.

What is bankruptcy?

Bankruptcy is a federal legal process consumers and businesses can use to reorganize their debts and establish a better financial foundation. The result of bankruptcy depends on which type you file. You may receive a clean slate by wiping out your eligible debts, or you may need to repay a portion of your debt.

Filing bankruptcy allows debtors to get breathing room to prioritize their financial obligations. Derek Jacques, a consumer bankruptcy attorney at Mitten Law in Southgate, Michigan, said: "Filing for bankruptcy provides a temporary stay of collection activities against the debtor and their property. Bankruptcy provides a way out of a stressful situation and gives debtors a chance to recover financially."

While you can file bankruptcy on your own, most filers work with an attorney. Attorneys charge a fee to cover their time and expenses. Additionally, the federal court charges a filing fee when you file for bankruptcy.

Types of bankruptcies

While the average person thinks of bankruptcy as a single action, there are actually multiple types of bankruptcy filings. The type of bankruptcy you file depends on who you are, how much you owe and your ability to repay some or all of your debts. These are three of the most common forms of bankruptcy.

• Chapter 7: This bankruptcy is known as a "fresh start" because it liquidates a debtor's nonexempt property, distributes the proceeds to creditors and wipes away most remaining debt. Consumers and businesses are eligible to file Chapter 7.
• Chapter 11: This bankruptcy type is primarily used to restructure the debts of corporations or partnerships, but it can also be used to create a repayment plan for high-income individuals.
• Chapter 13: This type of bankruptcy is a repayment plan that allows debtors to keep their property and repay some or all of their debt over a three- to five-year period based on their income level. Individuals and sole proprietors are eligible for Chapter 13.

The bankruptcy code also provides relief for municipalities (Chapter 9), farms and fisheries (Chapter 12), and other types of debtors, including those who file bankruptcy outside the U.S. (Chapter 15).

Reasons for filing for bankruptcy

There are many different reasons why someone might seek protection from creditors through bankruptcy. While some people assume that being bankrupt means you have no money, the reality is much more complex.

Here are some of the most common reasons why a person or company files for bankruptcy.

• Medical debt: Sickness or injury can lead to massive medical bills, even if you have a solid medical insurance policy. Additionally, a medical situation may limit your ability to earn income while you recover or take care of someone else.
• Divorce: Divorce can significantly affect your finances. Divorce attorneys can be expensive, and your share of joint debt can be overwhelming on one income or after accounting for spousal and child support.
• Job loss: Whether you're living paycheck to paycheck or comfortably on your current income, if you or your spouse loses a job, it can wreak havoc on your finances.
• Judgment against you: Getting sued is expensive when you factor in attorney bills, court costs and potential judgments against you or your business. Depending on the case, a judgment can exceed your insurance policy limits, net worth and ability to repay.
• Overbearing contract terms: Some contract terms are so one-sided you need a bankruptcy judge to help negotiate and right-size the terms to make them more affordable for you. While this approach is primarily used for business owners, it can be applicable to consumers as well. For example: Your rent is much higher than market rates, or your loan interest rate is so high that it qualifies as usurious.
• Failed business: According to the online resource Chamber of Commerce, nearly 1 in 5 businesses fail in the first year, and 50% fail after five years. A business failure can leave you with substantial debt and no way to pay it back.

Filing for bankruptcy can carry a stigma, but it’s nothing to be ashamed of. In many cases, circumstances beyond your control can overwhelm your finances, and bankruptcy is the only reasonable path out.

» MORE: Does medical debt affect your credit score?

Pros of filing for bankruptcy

There can be many positive outcomes of filing for bankruptcy. These may include:

• Getting a fresh start: Filing for bankruptcy hits the reset button on your finances and allows you to get out from under your debts.
• Finding relief from creditors: When you file bankruptcy, it immediately stops harassing phone calls, collection notices in your mail, foreclosure on your home, wage garnishment and more. Depending on which type of bankruptcy you file, you may still have to repay some of your debt, but a judge must approve any payments to ensure you can reasonably make them.
• Asset protection: You don't have to lose your assets to your creditors. Filing bankruptcy can prevent home foreclosure and allow you to reaffirm debts you want to keep (like a car payment) while getting rid of debts you don't (like credit card debts).
• Reducing or eliminating interest charges: If you must repay your debt, the bankruptcy judge has the power to reduce or eliminate your interest charges. You may only have to repay a fraction of the debt you owe.
• Emotional relief: Overwhelming debt can significantly hurt your physical and mental health (and your family’s). Filing for bankruptcy may reduce that stress and can be a positive step toward regaining control of your finances.

Cons of filing for bankruptcy

While bankruptcy eliminates some financial concerns, it has its drawbacks. It is important to understand how this impacts you when you’re deciding whether or not to file.

• Effect on credit score: Your credit score typically takes a hit when you file for bankruptcy. Even your accounts in good standing are included in the bankruptcy, which magnifies this impact. A bankruptcy stays on your credit for up to 10 years. However, the impact to your credit score lessens over time with responsible use of credit after your bankruptcy is complete.
• Legal costs: Filing for bankruptcy can be expensive when you factor in attorney fees, court costs, time away from work to attend hearings and other costs. Attorney fees for a Chapter 7 bankruptcy ordinarily range from $1,200 to $2,500.
• May not include all debts: Filing for bankruptcy does not automatically eliminate all of your debt. Some debts, like student loans, are harder to discharge in bankruptcy.
• Repayment may be required: Depending on your income and allowed expenses, you may have to repay some or all of your debts. Chapter 13 repayment plans generally last for three to five years.
• Higher borrowing costs: You can apply for loans and credit cards again after your bankruptcy has been discharged. However, lenders often charge higher interest rates and fees to people who have gone bankrupt before because there's a higher risk they’ll do it again.

How to file for bankruptcy

If you think that bankruptcy is right for your situation, follow these steps to file a Chapter 7 or Chapter 13 bankruptcy case through an attorney.

1. Meet with an attorney. Search for a local bankruptcy attorney to ensure you're eligible to file and determine which bankruptcy type is best for you. Most attorneys require a down payment to start your case and payment in full before your paperwork is filed.
2. Assemble your paperwork. The attorney must include all of your income, assets and debts when filing your bankruptcy case. While your credit report includes most debts, you'll need to verify that everything is there and list all of your assets and sources of income. You can get your free credit report from all three major credit bureaus at AnnualCreditReport.com.
3. Attend credit counseling. You must take a credit counseling course approved by the U.S. Trustee Program before you can file your Chapter 7 or Chapter 13 case. You can take these classes online or over the telephone.
4. Sign your bankruptcy forms. Review and sign your bankruptcy forms so they can be filed with the court. If any information is incorrect or missing, let your attorney know so they can update the forms and have you sign the corrected version.
5. Pay filing fees. The bankruptcy court charges filing fees for each type of bankruptcy. Depending on your total household income, you may qualify for a waiver of these fees or be allowed to pay in installments.
6. File your forms with the court. Your attorney will file your bankruptcy forms with the court. In most districts, this is done electronically. Once the forms are filed, you'll receive a case number, the name of your bankruptcy trustee, and the date, time and location of your 341(a) meeting (creditors meeting).

After you file

Filing your bankruptcy paperwork is not the final step in your bankruptcy case. After your case has been filed with the court, you must complete a second credit counseling class.

You must also attend a 341(a) meeting. At this meeting, the court verifies your identity and asks basic questions to confirm your filing on the record.

Creditors may also ask questions about your financial condition. Your answers may determine if they want to object to the discharge of your debts. Be sure to bring official identification, recent pay stubs, the last two months of bank statements and a copy of your bankruptcy forms to the meeting.

When to file for bankruptcy

While there aren't exact rules for when to file bankruptcy, here are some indicators that suggest it’s something you should at least consider.

• You cannot make your minimum monthly payments.
• Your home is on the verge of foreclosure.
• You've reduced your monthly expenses as much as you can.
• Your wages have been garnished.
• A large judgment was just awarded against you.

If you're still unsure about filing bankruptcy, consider booking an appointment with a bankruptcy attorney. Most provide a free consultation to determine whether bankruptcy is right for you.

Alternatives to filing for bankruptcy

Filing for bankruptcy isn't the only option if you’re having trouble repaying your debt. Before going down this path, consider these alternatives.

• Get a debt consolidation loan: A debt consolidation loan pays off your existing debt and consolidates it into a loan with one monthly payment amount. Often, you can lower the interest rate or extend the term to reduce your monthly payment amount. The focus on paying down the balance owed puts you on a path to being debt-free at the end of the loan term.
• Negotiate with your creditors: Contact your creditors to negotiate your interest rate, the amount owed and repayment terms. They may be willing to renegotiate your terms so you can avoid filing for bankruptcy.
• Open a balance transfer credit card: If you can qualify, apply for a balance transfer credit card with a low interest rate. Many of these cards offer promotional interest rates as low as 0% for 12 to 21 months, which can help you pay down your balance faster.
• Borrow from friends and family: Your friends and family may be able to gift or lend you money to take care of your debts. Keep in mind that could cause problems in your relationship if you’re unable to repay them.
• Sell assets: Consider selling unused or rarely used assets and putting the proceeds toward paying down your debts. Downgrading your car or moving to a lower-cost home can also free up extra cash.
• Increase your income: You can put more money toward your debt if you boost your income by getting a second job or starting a side hustle. In a strong job market, you may benefit from switching companies or taking classes to learn new skills.

» MORE: How to get out of debt

Bottom line

When you're in serious financial distress, filing for bankruptcy may be your best option. There are different types of bankruptcy based on how much you owe and your ability to repay. Bankruptcy halts debt collection efforts until the court decides how much, if any, of your debt should be repaid.

That said, filing for bankruptcy can negatively impact your credit score and ability to borrow in the future, so consult a bankruptcy attorney to determine if it’s the best course of action for you.