There's good news and bad news on the U.S. bankruptcy front.
According to U.S. federal government figures, bankruptcies have fallen from 1.6 million bankruptcies in 2010 to 770,000 cases in 2018, with 97% of those cases being consumer bankruptcy cases.
The idea behind bankruptcies, especially Chapter 7 bankruptcies, which represent the most common form of consumer bankruptcies, hasn't changed a bit. It's a way for Americans down on their financial luck to sell off assets and have specific debts discharged by a bankruptcy court.
Even as bankruptcies are in decline, it's useful to know what happens when one undergoes Chapter 7 bankruptcy. It's not a warm and fuzzy subject, but it's worth understanding if financial peril ever comes into play.
Here's the deal.
What Is Chapter 7 Bankruptcy?
Chapter 7 bankruptcy is the fastest and most efficient form of individual consumer bankruptcy.
The upside for those who go into Chapter 7 bankruptcy is that a host of serious debts, including credit card, medical and personal loan bills are discharged. By and large, that's what Chapter 7 bankruptcy does - it gets rid of a big chunk of the individual's unsecured debt, and gives them a chance to get back on their feet financially.
According to Debt.org, Chapter 7 bankruptcy is highly effective in discharging large unsecured debts. In 2016, for example, over 95% of all Chapter 7 bankruptcy cases saw most or all unsecured debts discharged.
Also, in virtually all Chapter 7 cases, the bankrupt individual is allowed to keep his or her primary residence.
How to Qualify for Chapter 7 Bankruptcy
Qualifying for Chapter 7 bankruptcy isn't all that easy, as there is a fairly stringent means test involved in the getting the green light to go ahead with bankruptcy proceedings.
Knowing what the means test is looking for is the first item on a consumer's Chapter 7 checklist.
The goal of the Chapter 7 bankruptcy means test is to determine if the filer can or cannot pay his or her debts.
The calculation to determine that status is simple - the Chapter 7 filer's primary monthly consumer (but not business) expenses are deducted from his or her average 6-month income (estimated over the past six month's worth of income.) The number left is the bankruptcy candidate's disposable income.
If that disposable income figure is too high, the bankruptcy candidate's chances of being approved for Chapter 7 bankruptcy are remote. In that scenario, the consumer is expected to use his or her disposable income to pay off any household debts.
The federal government has established a "median" monthly income as the benchmark for qualifying for, or being rejected, for Chapter 7 bankruptcy. That figure is based on a state-by-state criteria, with a bankruptcy filer in a high-income state like Massachusetts having a higher median income number to clear than a filer from a low-income state like Mississippi.
If you pass that means test, you will likely be approved for Chapter 7 bankruptcy.
By and large, if your financial situation falls into the following categories, you'll pass the test:
- Your household debts account for more than 50% of your annual income.
- You would need five years or more to pay off all of your unsecured debts.
- Your household debt is taking a huge emotional toll on your life, with sleepless nights and ruined marriages both common examples of stress-related events that lead to bankruptcy court approvals.
- You have no or low disposable income.
- Your monthly income falls under the median income criteria for your home state.
Once you're approved for a Chapter 7 bankruptcy, expect the entire process to take between 90 and 120 days.
What's the Difference Between Chapter 7 and Chapter 11 Bankruptcy?
Chapter 7 bankruptcies differ from Chapter 11 bankruptcies in multiple ways.
First, Chapter 7 bankruptcies primarily involve individual filers, while Chapter 11 bankruptcies mostly involve businesses and corporations.
That difference impacts how each bankruptcy is structured.
- In Chapter 7, the filer's financial assets are sold off to pay affected lenders and creditors.
- In Chapter 11, the filer reaches an agreement with lenders and creditors to renegotiate the terms of the loans so the bankrupt entity can more easily pay its debts, without having to sell any assets. In virtually all cases, businesses who enter into Chapter 11 get to keep their businesses running, and have a chance to climb out of debt, thus making Chapter 11 a business reorganization opportunity.
Legal structure isn't the only difference between Chapter 7 and Chapter 11 - money factors in, too.
For example, most filing fees for Chapter 7 are fairly low - usually at around $300-to-$350. That's not the case with Chapter 11 bankruptcy filings, which can run as high as $1,700, according to the legal website, Nolo.com.
The time frame for both forms of bankruptcy differs, as well.
Chapter 7 bankruptcies can be disposed of within four months (unless it's a business bankruptcy, which can last a year or so.) In most cases, Chapter 11 bankruptcies can take several years to wind down.
Essentially, the decision to file for Chapter 7 or Chapter 11 bankruptcy depends on your personal situation.
- If you're an individual under severe financial stress, Chapter 7 has more to offer, as it allows you to keep your home and significantly curb your unsecured debt burden.
- If you're a business owner looking to buy some time, hang on to your company, and negotiate your outstanding loans and debts, a Chapter 11 bankruptcy fits the bill.
Pros and Cons of Chapter 7 Bankruptcies
Considering it actually is a bankruptcy deal, Chapter 7 filings offer a fair share of "pros" against some significant "cons."
Pros of Chapter 7 Bankruptcies
Keep Your Assets The first big pro is that mostly, filers don't give up personal assets. That means big-ticket possessions like a home, computers and phones, and the family vehicle are considered hands-off to creditors in a Chapter 7 case.
If You Can't Pay, Chapter 7 Is a Way Out While it's usually best to pay off unsecured debts, to protect your credit rating and keep interest on loans and credit cards low, Chapter 7 does make sense if your debt is higher than 50% of your yearly income. In that case, Chapter 7 bankruptcy can get you on the path to a debt-free life and significantly reduce the filer's financial stress.
It Gets Collection Agencies Off Your Back
Anyone who's ever dealt with a persistent collections agency can tell you how nerve-racking it can be to be targeted for a debt repayment. Regular phone calls, threats to your financial standing, and nasty letters, texts and emails are par for the course for collections agencies.
With Chapter 7, those aggressive collection agencies largely go away, giving you a measure of peace as you rebuild your financial life.
Cons of Chapter 7 Bankruptcies
You Don't Discharge Personal Debts Under Chapter 7, bankruptcy filers still have to make good on personal debts like alimony and child support, college loans, and taxes owed to the government.
There Are Serious Financial Ramifications Filing for Chapter 7 bankruptcy means, among other negatives, that the bankruptcy will remain on your credit report for 10 years, identifying you, fairly or unfairly, as a deadbeat on your loans and credit. Any attempt to get new credit (like for a new mortgage) will be an uphill climb, and even if you qualify, expect to pay sky-high interest rates on your loans and credit.
You'll Forfeit Your Credit Cards When you go through the Chapter 7 bankruptcy process, don't expect to keep your credit cards - they'll be canceled by your card provider.
Maybe that's a plus, though. After all, you can't go into heavy card debt if you're not abusing your plastic privileges.
Chapter 7 Bankruptcies are More Real Than You Might Think
History is chock full of bankruptcies that have taken the financial starch out of famous U.S. citizens.
Take Abraham Lincoln, the nation's 16th president and one of the most revered historical figures in American history.
Yet in 1833, a young Lincoln declared bankruptcy after a business he owned went under. His penalty for doing so was severe - Lincoln spent 17 long years repaying his creditors before he regained his financial footing and embarked on his journey to the U.S. presidency and the history books.
Lincoln was hardly alone. Celebrated figures like Walt Disney, Henry Ford, Milton Hershey, and yes, President Donald Trump also declared bankruptcy before they rebounded in spectacular fashion.
That doesn't mean you will, too, however.
In fact, the best bankruptcy strategy is to avoid one at all costs. Unless, that is, you have no choice and have to file for one of the most severe, but under-appreciated financial filings under U.S. law.
In that case, you got to do what you got to do.
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