How Does Bankruptcy Work?

Bankruptcy works by either erasing most or all of your debt, or by compartmentalizing your debt so that you can repay it over time.

At its heart, bankruptcy is a way to reset your finances when you’re overwhelmed with debt. Depending upon the type of bankruptcy, it can either erase most of your debts or it can compartmentalize your debt so that you can systematically repay it over time.

There are any number of reasons why someone might be swamped with debt, but more often than not the reason is medical debt. An unexpected injury, illness, or hospital stay can result in someone being buried in debt with no possible way of ever digging themselves out. In fact, more than 66 percent of all bankruptcies are triggered by medical debt.

How Do Bankruptcy Courts Work?

Bankruptcy works by petitioning a federal court to give you a fresh start. It’s handled in federal court because bankruptcy law is Title 11 of the United States Code. While most federal courts handle either civil or criminal cases, bankruptcy court is separate and apart from those two types of courts. Federal bankruptcy laws outline six different types of bankruptcy, each of which are applicable to different types of people or entities. The two that individuals use are Chapter 7 and Chapter 13.

How do Chapter 7 and Chapter 13 Differ?

Chapter 7 provides for the liquidation of all of your assets. Once your assets are cashed out, then the money is distributed to your creditors and the rest of your debt is erased. Once this happens, creditors and debt collectors are not allowed to try and collect that discharged debt.

Chapter 13 provides for the reorganization of your debt. Depending upon your income, you enter into a repayment plan that lasts three to five years. If at the end of that time you’ve fulfilled your repayment commitments, then the remainder of the debt covered under the bankruptcy will be discharged. That means that creditors can no longer attempt to collect those debts.

What are the Steps in Bankruptcy?

If you are considering filing for bankruptcy, your first step should be to consult a bankruptcy attorney. Bankruptcy is not a DIY process. You’ll do the preliminary work with your bankruptcy attorney, and then you’ll file a petition with the bankruptcy court in charge of the area where you live. The court papers you file will include exhaustive financial information, including:

  • Assets and liabilities.
  • Current income and expenditures.
  • Contracts and leases.

You must also demonstrate that you have participated in legally mandated credit counseling and produce the repayment plan you worked on during credit counseling.

Once you file for bankruptcy, you receive an automatic stay, which prohibits most types of creditors and debt collectors from pursuing further collection actions. This can give you the breathing room you need to take the next steps in your bankruptcy proceeding.

Your case will be assigned a trustee, and the trustee will schedule a meeting of your creditors. During the meeting, you’ll be asked questions under oath about your financial situation. If you are filing under Chapter 7 of the Bankruptcy Code, then the trustee will liquidate your assets and distribute them to your creditors. When the bankruptcy court recognizes that the process is complete, then your remaining eligible debts will be discharged, meaning that you no longer owe them and that creditors can no longer try and collect those debts or sue you for repayment.

If you are filing under Chapter 13, then you’ll attend a hearing with the judge, the trustee, and your creditors. During this confirmation hearing, the judge typically approves your repayment plan, which is devised based on your debts and your calculated disposable income. If you receive a regular paycheck, it’s common to have a set amount deducted and forwarded to the trustee, who will in turn pay the creditors named in the plan. Otherwise, you are responsible for sending your payment to the trustee. At the end of the repayment plan (typically three to five years), the remainer of the eligible debts listed in the repayment plan are discharged. You no longer owe that money and creditors are prohibited from trying to collect it or from suing you in a court of law.

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