Most common types of bankruptcy

Chapter 7 is the most comprehensive form of bankruptcy and can be used by all businesses and persons. It discharges most unsecured debts, and any remaining funds are applied to those debts after all secured creditors are paid. Chapter 13 is normally used by individuals and small businesses as a means of reorganizing, delaying and reducing payments to creditors over an extended period of time. Chapter 11 is similar to Chapter 13 but is typically used by large businesses and has many more requirements in order to qualify. Of the three, Chapter 7 has the most significant effect on the credit rating.

What you do and don’t pay

A Chapter 7 proceeding will force the surrender of property that is not exempt from the liquidation. Depending on state law, exempt property normally includes the necessities of life such as household goods, certain health aids, clothing, tools of your trade, and a used automobile. The bankruptcy judge will appoint a trustee who will liquidate the remainder of the property, and the proceeds of the liquidation are apportioned to the creditors. The debtor will then be relieved of some, but not all of his debts.

Some debts that are not normally discharged include those not filed with the court in the declaration, unpaid taxes, government education loans, personal injury debts resulting from DWI, alimony and child support, government-imposed fines and penalties, and loans from tax-advantaged retirement plans such as 401(k) accounts. As a general rule, secured creditors maintain legal rights to their collateral even if the debt is discharged. So a car purchased with secured financing may still be repossessed even though the loan has been discharged. Chapter 7 is only available once every eight years.

In Chapter 13, you retain ownership and possession of your assets so they are not subject to liquidation by the court. However, you must have a validated future income stream that is capable of repaying creditors based on a restructured payment schedule over a period of several years. Secured creditors are usually allocated a greater proportional share of the income than the unsecured creditors.

Effect on future credit

The bad news is that a Chapter 7 bankruptcy remains on your credit report for ten years. The good news is that you can start to repair your credit record the day after the bankruptcy judgment is final. While your credit score will take a severe hit and make credit of all kinds much harder to obtain, potential lenders also know that you now have little or no debt. In some ways, you are a better risk than other people who are burdened with debt and are living from paycheck to paycheck. In a manner of speaking, you now have a clean credit slate and this is your chance to take advantage of that. The one thing you don’t want to do is find yourself back in front of a bankruptcy judge again.

If you used Chapter 7, there are certain things you can do to start to improve your credit score. The first step is to review your credit report and ensure that it properly reflects the bankruptcy judgment. Debts that were discharged should be reported as such. If you are employed, take part of your paycheck and have it automatically deposited into a savings or CD account and a 401(k) account if offered by your employer. This will demonstrate to potential lenders that you are serious about setting money aside for a rainy day and your retirement.

The cardinal rule is that you have to get and use credit in order to improve your score. So while it’s important to save, there are things you can do on a small scale to get the ball rolling. One option is to get a secured credit card and use it lightly and regularly. Your limit will be set according to collateral you establish with the issuing financial institution. If you are responsible with the card and pay your entire balance every month, there’s a good chance you will eventually be upgraded to an unsecured card.

In addition to the revolving credit offered by a credit card, you also want to establish a line of installment credit. If you have any student loans that survived the bankruptcy, pay those down as rapidly as possible. If you need a car, some auto dealers specialize in financing individuals with poor credit. You may be paying a steep interest rate at the start, but that is the price you may have to pay for getting yourself into the financial predicament that brought you to bankruptcy. If you pay that loan responsibly, you can later try to refinance it with better terms.

How bankruptcy may affect your spouse

For debts that were initiated by one spouse alone, without the written consent of the other spouse, the discharge of those debts will not affect the other spouse. You are responsible for your own debts and that carries through in a bankruptcy proceeding. However, if your spouse has cosigned or guaranteed a loan, then both of you are responsible for that debt and nonpayment will affect both of you. This also applies in the event that your spouse possesses a supplementary credit card that is tied to the same master account. Any joint debts that are discharged through bankruptcy will affect the credit rating of both spouses. Also, if one spouse declares bankruptcy for individual debts, that spouse will likely be disqualified from cosigning any future loans with the other spouse.

An option of last resort

For the vast majority of people, bankruptcy should be the option of last resort when other solutions aren’t feasible. It will severely damage your credit rating and your life will now be under the financial control of a bankruptcy judge. There is also the stigma and embarrassment that is suffered by many people who never thought they would ever find themselves in such dire straits. But for some people with nowhere else to turn, bankruptcy can be the springboard that offers a permanent solution to completely turn their lives around. For them, bankruptcy is a wakeup call that teaches valuable lessons on how to avoid the mistakes of the past. They get their act together, establish a budget, control their spending, alter their lifestyles, and start saving as aggressively as possible for the future.

Bankruptcy Statistics

With the economy now in recession and the housing bubble imploding, the number of bankruptcies has increased dramatically. The number of Chapter 7 bankruptcies increased year-over-year by 37% between June 2007 and June 2008. The average age of filers is 38 and two out of three have recently lost their jobs. About half of them have experienced a serious health crisis that was not fully covered by insurance, or they had no insurance. 44% are couples, 26% are men filing individually, and 30% are women filing individually. The typical family that filed owed more than 150% its annual income in high interest debt, predominantly from credit cards.