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How It Works, How to Prevent It

It's not something you like to think about, but you may find yourself considering bankruptcy at some point in your life. How do know if it's the right thing for you? Can you prevent it?

What is Bankruptcy?

Bankruptcy is a federal court process that helps individuals and businesses repay their debts under the protection of the bankruptcy court (Chapter 13 Bankruptcy) or wipe their debts out altogether (Chapter 7 Bankruptcy). When you file for bankruptcy, an automatic stay goes into effect which prohibits your creditors from taking action to collect the debt without the approval of the court.

There are two basic types of bankruptcies: liquidation or reorganization. In the US, liquidation is known as Chapter 7 Bankruptcy, which refers to the chapter of the bankruptcy law that allows your assets to be sold off (liquidated) to pay creditors. Reorganization is most commonly known as Chapter 13 Bankruptcy.

Reorganization Bankruptcies (Chapter 11, 12, or 13)

Reorganization bankruptcies fall under Chapter 11, 12, or 13, with Chapter 13 applying to most individuals. In any reorganization bankruptcy, you file a repayment proposal with the bankruptcy court. Some debts must be repaid in full, some are repaid as a percentage of the original debt, and others aren't repaid at all. Payment plans usually cover three to five years.

Some debts cannot be discharged or "forgiven," including:

  • Debts you forget to list in your bankruptcy papers
  • Child support and alimony
  • Debts for personal injury or death caused by driving while intoxicated
  • Most student loans
  • Fines and penalties imposed for breaking the law, such as traffic tickets and criminal restitution
  • Most tax debts

During the repayment period, the court will place restrictions on how you can spend money. In many cases, a set amount will be garnished from your wages and a trustee of the court will make the payments to your creditors.

If you stick with the repayment plan until the end, you may find that creditors will grant you credit at the end of the repayment period, even though the bankruptcy will stay on your credit history for six years.

Liquidation Bankruptcies (Chapter 7)

In a liquidation bankruptcy, you turn your personal property (with a few exceptions) over to the court, which sells it and uses the proceeds to pay your debts (or a portion of your debts). Creditors can no longer come after you for payment, but the bankruptcy stays on your credit history for 10 years and you may be denied credit during that period.

Under the new bankruptcy law passed in 2005, your income must be below the median income for the same size family in your state or you will be required to go through a bankruptcy means test, which places severe restrictions on your spending. For instance, you will be allowed approximately $200 a month for food and less than $800 a month for housing and utilities. If the court believes that you have $100 or more per month in disposable income that you could apply towards your debt repayment, you'll be pushed into a repayment plan under Chapter 13 instead of qualifying for Chapter 7.

Filing for bankruptcy has serious consequences and should not be entered into lightly. Having your debts erased doesn't miraculously solve your long-term financial problems if you have irresponsible spending habits, but sometimes it's the only way out of a crushing financial burden caused by job loss, medical bills, or other circumstances that are out of our control.

Preventing Bankruptcies

Many bankruptcies can be avoided by practicing good money management. For example, avoid impulse spending, don't use a credit card unless you have the cash to pay it off, tear up credit card offers you receive in the mail, stick to a realistic budget, don't buy more house than you can comfortably afford, make sure you're adequately covered by insurance (medical, homeowners, auto), don't make speculative or high-risk investments, don't incur joint debt with others who have questionable financial habits.

If you do find yourself behind on your bills, call your creditors before you get in too deep. Most creditors will work with you if circumstances (job loss, divorce, illness, etc.) have made it temporarily difficult for you to meet your financial obligations. Suggest a temporary reduction in your payment, a waiver of late fees or penalties, skipping several payments now and increasing future payments to make up for it, or skipping several payments and adding them to the end of the loan. Some people successfully use credit counseling services to help negotiate with creditors, but make sure the business is legitimate and reputable.

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