How to know when to file bankruptcy: Tips and considerations

It can be confusing to distinguish between the different types of bankruptcy and to know when it's appropriate to file for it.

In this guide, we'll cover Chapter 7 and Chapter 13—the two most common types of bankruptcy—and will explain what happens when you declare bankruptcy, how to do so, and questions you should ask yourself to determine whether bankruptcy is right for you.

Overview: What is bankruptcy?

Bankruptcy is a legal process for individuals or companies that are unable to pay their outstanding debts. You can go bankrupt in one of two main ways. The more common route is to voluntarily file for bankruptcy. The second way is for creditors to ask the court to order a bankruptcy.

If you decide to file for bankruptcy yourself, there are several ways to do so. You may want to consult a lawyer before proceeding so you can figure out the best fit for your circumstances.

Chapter 7 vs. Chapter 13: What's the Difference?

Chapter 7 and Chapter 13 bankruptcies are two different approaches to resolving outstanding debts:

• Chapter 7: Liquidate your assets and pay off debt with cash
• Chapter 13: Work out a payment plan for unresolved debts

What Is Chapter 11?

There are other types of bankruptcy filings that are less common and more costly for small businesses, such as Chapter 11. This type of bankruptcy is for businesses with $2.5 million or more in debt, or for businesses owned by LLCs or partnerships. A Chapter 11 bankruptcy is similar to Chapter 13 but is usually only for businesses.

This type of bankruptcy:

• Involves a creditors' committee appointed by an independent trustee
• Reorganizes the company according to a plan that creditors vote on
• Sets up a payment plan for the company to repay its debts

The Small Business Reorganization Act of 2019 made Chapter 11 less costly for small businesses, allowing them more flexibility to negotiate terms of the bankruptcy with creditors. But this is still much less common than Chapter 13. You may want to speak with a lawyer if you feel like a Chapter 11 bankruptcy is right for your company.

What happens when you declare bankruptcy?

Filing a bankruptcy petition automatically stays your creditors' claims against you. This means that your creditors have to stop trying to collect the money you owe them. They will not be able to:

• Call you to collect debts
• Repossess your car
• Foreclose on your home

Your case will be assigned to a bankruptcy trustee, who is a lawyer who will oversee your case. The trustee will send notices to your creditors and schedule a hearing.

From there, the procedure depends on whether you've filed for protection under Chapter 7 or Chapter 13 of the federal Bankruptcy Code.

What Happens When You File Chapter 7?

Chapter 7 is one of the most common types of bankruptcy. In a Chapter 7 bankruptcy, you will:

• Forfeit many of your assets to be sold for cash
• Pay your creditors with the money from your asset liquidation

There are certain assets—such as a limited amount of cash, clothing, household items, and a car—that you are allowed to keep, but these exemptions vary depending on the state you live in.

Once your assets are liquidated and creditors are paid, any remaining debts you owe are forgiven unless you've reaffirmed the debt. Debt reaffirmation is when you voluntarily waive protection through the bankruptcy discharge and agree to remain responsible for the debt. Reaffirmation is chosen to retain certain assets and avoid liquidation.

Not everyone can file a Chapter 7 bankruptcy. If your income is too high, you may be required to file a Chapter 13 bankruptcy instead.

What happens when you file Chapter 13?

If you can't file a Chapter 7 bankruptcy, or if you have some money to pay creditors and there are assets that you want to keep, a Chapter 13 bankruptcy may be an option for you. In a Chapter 13 bankruptcy, you will:

• Develop a plan for making payments to your creditors over a three-to-five-year period, depending on your income
• Make all of your payments on time to said creditors
• Complete a budget counseling course

After these milestones are complete, the remainder of your debt that is eligible for discharge will be erased.

Chapter 13 is a good option for someone with a steady income who has some money left over every month to make debt payments but who needs some breathing room and extra time to get caught up.

How does bankruptcy affect assets and liabilities?

Depending on how you choose to declare bankruptcy, your assets and liabilities will be affected in different ways. In a Chapter 7 bankruptcy, many of your assets are up for liquidation to pay your creditors with the proceeds. In Chapter 13, you retain assets while working on a repayment plan for your outstanding debts.

See how bankruptcy affects assets and debts in the following debtee categories.

Small business owners

For small business owners with lots of personal debt, bankruptcy may help them continue to stay in business. It's important to note that business debts aren't alleviated with Chapter 7 or Chapter 13 unless you're a sole proprietor and are personally responsible for them.

• Chapter 7: For sole proprietors, business and personal debts can be wiped out in a single bankruptcy case. You're not obligated to meet income requirements if your business debt exceeds your personal debt.
• Chapter 13: Your business assets aren't liquidated, but only your personal liability for business debts can be wiped out. The business remains responsible for its debts.

Some business assets can be exempt from Chapter 7 bankruptcy filings. For instance, if your business is service-based and doesn't maintain equipment or significant inventory, you can likely continue to run your business after discharging business debts through bankruptcy.

Student loan holders

No form of bankruptcy can relieve student loan debt. Certain people, such as some government employees, are eligible for student loan forgiveness unrelated to bankruptcy filing.

If you need help managing your student loan debt, you should look to your creditor to help manage repayment options or look into debt consolidation.

Mortgage holders

In a bankruptcy petition, your home and mortgage will be noted as assets to determine your ability to repay. Depending on the type of bankruptcy filing you pursue, your mortgage might be affected in different ways:

• Chapter 7: Your home can be liquidated to repay your debt unless you reaffirm your mortgage and assume responsibility for repayment post-bankruptcy.
• Chapter 13: Your home is not liquidated, and you're responsible for paying your loan under the terms set by your repayment plan under the bankruptcy.

If you choose to reaffirm your mortgage in a Chapter 7 bankruptcy, you could be stuck with the liability for your loan after your bankruptcy proceedings. If you're unable to repay, you won't be able to declare Chapter 7 bankruptcy again for several years, and creditors may be able to sue you to collect on the loan.

How do I declare bankruptcy?

To declare and file bankruptcy, you are required to complete a credit counseling class to learn about bankruptcy, alternative options, and managing your finances on your own.

After completing the course, you must submit a petition to the U.S. bankruptcy court in the federal judicial district where you live. This petition will list your:

• Assets, such as cars, homes, and bank accounts
• Monthly income and expenses
• Creditors and how much you owe them

You'll also need to submit a copy of your most recent tax return with your petition. You can have an attorney prepare the petition for you, or you can obtain bankruptcy forms and instructions from the U.S. courts.

Filing for Chapter 7

Chapter 7 is sometimes referred to as a "straight bankruptcy." A Chapter 7 bankruptcy liquidates your non-exempt assets to pay off as much of your debt as possible. The cash from your assets is distributed to creditors like banks and credit card companies, and you typically receive a notice of discharge within four months.

To file Chapter 7, you must pass a bankruptcy means test. The only people exempted from this are disabled veterans filing for bankruptcy to discharge debt incurred while they were on active military duty or people with debt that comes from operating a business.

The record of your bankruptcy will stay on your credit report for 10 years. But for many people, Chapter 7 offers a fresh start.

Filing for Chapter 13

A Chapter 13 bankruptcy is also known as a reorganization bankruptcy. Chapter 13 enables people to pay off their debts over a period of three to five years. For individuals who have consistent, predictable annual income, Chapter 13 offers a grace period. Any debts remaining at the end of the grace period are discharged.

Once the bankruptcy is approved by the court, creditors must stop contacting the debtor. Bankrupt individuals may then continue working and paying off their debts over the coming years and still keep their property and possessions.

When to declare bankruptcy: 8 questions to ask yourself

Most people take their financial obligations seriously and want to pay their debts in full, but knowing when to file bankruptcy and when to negotiate or use another strategy can help put you on the road to financial health.

Here is a list of questions that can help you assess your financial health and give you insight into whether bankruptcy may be right for you. You should also discuss these questions with an attorney.

1. Do I only make minimum payments on my credit cards?

Credit cards typically carry high-interest rates on open balances. This means that your balance can quickly balloon if you're only making minimum payments. If your balance was high to begin with, it could spiral out of control quickly.

2. Do I get calls from bill collectors?

Constant phone calls from collectors can be irritating and stressful reminders of your debt. Contact each of your creditors and see if they are willing to negotiate a lower balance or lower monthly payments.

3. Do I use credit cards to pay for necessities?

Paying for basic necessities with a credit card causes those purchases to accrue interest. For this reason, you should aim to only pay for these items with a debit card.

4. Have I considered, or am I considering, debt consolidation?

Debt stems from many sources. Consolidating your payments into one large loan can help you more easily keep track of outstanding debts with one monthly payment. This can also extend more time to your repayment as the new loan will come with new payment terms.

5. Can I pay down debts by selling some possessions?

It can be hard to confront downsizing from a home or getting rid of a car, but taking these difficult steps could allow you to pay off debts and avoid a bankruptcy filing.

6. Do I owe more than I pay?

Your expenses should ideally be covered by your income with some buffer room for emergencies. If your monthly payments exceed your take-home pay, you're a potential candidate for bankruptcy.

7. Am I unsure how much I actually owe?

Uncertainty about your total outstanding debts is cause for concern. Whether your balances have grown larger and you're unaware of the total, or you've forgotten creditors that have sent your debt to collections, you should consider alternative repayment options if you can't tabulate how much you owe.

8. Will bankruptcy actually resolve my debts?

Bankruptcy does not resolve all debt indiscriminately. Some debts, such as student loans, cannot be discharged in bankruptcy. If you're having trouble making payments toward debts that bankruptcy won't cover, you should speak with your creditors to determine your options.