Most people think of bankruptcy as a remedy of last resort, something you do when all of your other efforts at managing your debt have failed. There is nothing in the bankruptcy law that requires you to pursue other options first, but it is a process which can be demoralizing and, in some cases, depending on your circumstances, it may not even give you the relief you need. For instance, if you have a lot of student loans or tax debt (which normally cannot be eliminated through bankruptcy), or own property which you need or want to retain, then bankruptcy may not be the route you should take.

Keep in mind that the fundamental purpose of bankruptcy is to give honest debtors (those who have not incurred their debt through fraud or other wrongdoing) a fresh start in their financial lives, while ensuring that creditors are treated fairly under the circumstances. What this means in any particular case depends on what type of bankruptcy you file, what types of debt you have, and which state you live in.

Chapter 7 Bankruptcy

Most individuals who file for bankruptcy protection do so under Chapter 7 or Chapter 13 of the Bankruptcy Code. Chapter 7 is the most common type of bankruptcy. In a Chapter 7 case, a trustee is appointed to take control of your assets, liquidate (sell) anything of value (usually nothing is actually sold – read on), and pay your creditors with the proceeds of liquidation. You are then discharged from any debt left over at the end of this process. In reality, however, the typical Chapter 7 consumer case does not involve the sale of any assets because under state law, you are entitled to certain exemptions of property. This is property you are allowed to keep from creditors. Even though bankruptcy occurs under federal law, each state determines what types of property are protected from creditors. The general idea of these exemption laws is to ensure that individuals are allowed to retain property necessary for basic needs, like household goods and clothing, cash for current living expes es, and to a limited extent the equity in your home. In most Chapter 7 consumer cases, once the debtor takes his/her exemptions, there is nothing left for the trustee to sell, and therefore, the case is closed as a “no-asset” case, creditors receive no payments, and the debtor is discharged from most debts (but see below regarding which debts cannot be discharged).

Chapter 13 Bankruptcy

Chapter 13 is a much more complex and lengthy process because it does not involve liquidation, but rather reorganization of your debts. The most common difference between an individual who files under Chapter 7 and one who files under Chapter 13 is that the Chapter 13 debtor owns a home with a mortgage which is in arrears or with a mortgage that is far below the market value of the house. A secured debt cannot be eliminated through bankruptcy. So, if someone who is in arrears on mortgage payments files under Chapter 7 to avoid foreclosure, the mortgage lender will soon come into the bankruptcy court and seek permission to foreclose, and in most cases, the court will allow the foreclosure. In a Chapter 13 case, the debtor will be given the opportunity to pay the arrearages over a period of 3 to 5 years (along with the normal, on-going mortgage payments), and the mortgage lender will not seek to foreclose unless the debtor falls behind on these payments.

Someone who owns a home, even if he/she is not late on mortgage payments, may choose to file under Chapter 13 if he/she has substantial equity in the property (equity that exceeds the exemption amount allowed in that state). In a Chapter 7 scenario, the trustee would sell the house and pay creditors with the proceeds (remember, Chapter 7 is liquidation). Under these circumstances, if you want to keep the house, the trade-off is that you have to pay your other creditors a reasonable percentage of what you owe them.

As with Chapter 7, in a Chapter 13 case, a trustee is appointed to administer your case. You file a Chapter 13 plan which provides how much you will pay to the trustee on a monthly basis (over 3 to 5 years), and if your plan is approved by the bankruptcy court, those payments are made directly to the trustee each month. The trustee then makes payments to your creditors.

How much you’re required to pay into your plan depends on your total debt, how much you have available from income after necessary living expenses, and how much equity you have in your home (the more equity, the more the trustee will expect you to pay to your creditors in exchange for your being allowed to keep the house).

Debts That Normally Are Not Discharged in Bankruptcy

Most taxes and other governmental charges or penalties
Student loans (except in limited hardship cases)
Alimony and child support
Debts incurred through fraud
Secured debts (mortgages, car loans, certain department store purchases)

Talk to an Attorney

These are the basic concepts under Chapter 7 and Chapter 13 of the Bankruptcy Code. However, every individual’s situation is different. Therefore, you should talk to an attorney to evaluate your options.