Understanding Bankruptcy: A Comprehensive Guide to Filing (Chapter 7)

“I declare … bankruptcy!” Somewhere along the way, that became the go-to phrase to describe the act of going the bankruptcy route. But as you might imagine, it’s far more complex than that. Here’s what you need to know about how to file bankruptcy and whether it might be right for you and your financial life.

How Much Do You Have To Be In Debt To File Chapter 7?

Filing bankruptcy is not something to be taken lightly … just because you have some debt that you’d like to “erase” and start over is not a reason for filing bankruptcy.

You may be wondering, “Should I file bankruptcy?” While there is no definite threshold and every situation is different, a general rule of thumb is that if your debts total more than half of your annual income and/or you don’t see a clear path for paying them off within 5 years, then filing for Chapter 7 bankruptcy might be your best bet as a way to protect your credit for the long run. Your ability to file Chapter 7 bankruptcy will also be based on your disposable income in relation to your income, which we will cover in more detail later.

So in a nutshell, when to file bankruptcy will be different for each person, but will depend on how far in debt you are and how insurmountable that debt seems.

What Happens If I Declare Bankruptcy?

As you might imagine, your financial woes won’t automatically disappear once you file bankruptcy. It’s possible you’ll still owe on some of your types of debt, and some people may not even be eligible for bankruptcy.

There are actually two types of bankruptcy: Chapter 7 and Chapter 13. Filing for Chapter 7, also known as a “liquidation bankruptcy,” means that you must sell, or liquidate, any assets that are backed by a tangible item, such as your house or car. Once these “secured” assets are disposed of, the rest of your unsecured debt, such as credit card or medical bills, will be forgiven in what’s called a “bankruptcy discharge,” which means you will not have to pay it back. However, there are some charges you may owe that will not be forgiven, including taxes, alimony, child support and student loans. 

It’s also important to know that the court won’t take everything in a bankruptcy, despite its name as a “liquidation” bankruptcy. As part of your Chapter 7 bankruptcy paperwork, you will compile an itemized list of all your property and compare it to the “exemptions” you can claim for each item. For example, some common federal exemptions include the “homestead exemption,” which means you can protect $25,150 of equity in the residence where you currently live; $1,700 for jewelry; $13,400 in household items, such as appliances, clothes and furnishings, with no one item worth more than $625; and $2,375 for “tools of the trade,” such as tools, machinery or computer equipment. These exemptions double if you are married.

Some states have their own exemption amounts, while others use the federal exemptions. And in some areas, you can choose whether your state or federal exemptions would be most advantageous to you. Search for the name of your state and “Chapter 7 bankruptcy exemption” to find out how your state will handle the exemptions.

Finally, many states and the federal rules offer a “wildcard” exemption which you can apply to any item of your choice.

What Do You Need To Do To File Bankruptcies?

First, remember that not everyone is eligible to file for Chapter 7 bankruptcy: It depends on your income and debts. How does bankruptcy work? It starts byensuring you can pass a means test, which will take into account your income, expenses and family size to determine if you have enough disposable income that you should be able to pay off your debts. The higher your disposable income, the less likely you can file for Chapter 7.

The first part of the means test will establish whether your household income is below your state’s median income for the prior 6 months. After verifying you are eligible from an income standpoint, the second part of the means test involves tallying up your “allowable expenses,” such as housing, utilities, groceries, out-of-pocket medical costs and other necessary expenses, based on a combination of federal guidelines and local standards. That’s how they decide how much of your income is deemed “disposable” and therefore should be applied toward your debt.

Once you’ve passed the means test, you can move forward with filing the rest of the bankruptcy paperwork – which is voluminous indeed. It’s wise to work with a bankruptcy attorney who can help you with the ins and outs of how to file correctly.

You’ll then file a petition with your local bankruptcy court (along with the appropriate filing fees), which will start the process of meeting with your bankruptcy trustee and creditors to determine how to handle your non-exempt property and your debts. You’ll need to complete mandatory credit counseling within 180 days of filing, using an approved agency, and also complete a financial management course, again through an approved agency.

What Are Advantages Of Filing Bankruptcy?

The main advantage to filing bankruptcy is the peace of mind that comes from having a go-forward plan in order to start anew to repair your financial life without the stress of financial burden weighing you down. In addition, with the majority of your unsecured debt erased, you can start fresh without worrying about crippling interest charges that continue to pile up, or having to figure out a repayment plan.

And, you’ll also be free from harassing phone calls from creditors or collectors. That‘s because as soon as you file, you’ll receive what’s called an “automatic stay,” which gives you legal protection from creditors.

Finally, while you will have some lingering credit problems, in the long run it will greatly help your credit score. Once you’ve erased the debt, though, it’s important to get to work immediately to start rebuilding your credit score.

What Is The Downside Of Filing For Bankruptcy?

First of all, of course, you will be liquidating a large portion of your property, which can be challenging. The exemptions can help, but you will still have to start over in some areas. And as noted earlier, it doesn’t take care of all the debt, such as student loans and family support, which you’ll need to continue paying.

In addition, the bankruptcy will sit on your credit report for 7 – 10 years, and it’s likely to make it more difficult to seek a mortgage or a personal loan. And some landlords or employers may check your bankruptcy status and look less favorably on it when comparing you to other candidates.

That’s why the timing of filinf bankruptcy is a very personal decision, based on your financial reality and goals.

Find out more here about how long it will take to improve your credit score and read this credit success story to see how it can be done!