What Is Bankruptcy?

Bankruptcy Explained

Definition

Bankruptcy is a legal process designed to help individuals and companies get a financial fresh start by discarding or making arrangements to repay unmanageable debt. It can also be a way for companies to end business and liquidate assets in an orderly way.

Couple reviewing bills at a computer and looking concerned
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Definition and Examples of Bankruptcy

Bankruptcy is a process that gives you a legal means of starting over financially when you can't afford to pay your debts. Depending on which type you file, the bankruptcy court decides how creditors will be paid; it can also collect and sell your assets and belongings or create a repayment plan.

For example, suppose you work full-time but can't afford everything you want, so you decide to max out all of your credit cards. However, you also have a mortgage, two car payments, and student loan debt—it's likely that you wouldn't be able to meet your debt obligations. So you choose to petition a bankruptcy court and are granted a Chapter 13 bankruptcy, where the court creates a repayment plan for you.

Note

Bankruptcy can have long-term financial and legal consequences. If you're thinking about filing for bankruptcy, then it's best to consult a lawyer who specializes in it. If you can't afford a lawyer, check with the American Bar Association to determine whether you qualify for free legal help.

How Bankruptcy Works

You must have had credit counseling from an approved agency to file for bankruptcy within the last 180 days. Once you've gone through the counseling, you can file a petition with the bankruptcy court in your judicial district. The court determines whether you're eligible to file, and it proceeds with your case or denies it.

You might not need to appear before the judge in a chapter 7 or 13 hearing unless an issue is raised that requires you to appear. However, you'll probably be required to attend the creditor's meeting at the U.S. trustee's office. If the court rules in your favor in a chapter 7 bankruptcy, you'll be given a discharge from some debts but not others—such as alimony or child support.

You'll also be required to attend a debtor-education course before your debts are finally discharged. Beyond these requirements, each bankruptcy chapter will have qualifying factors, fees, and required paperwork.

Note

Although there are several different types of bankruptcy and various qualifying factors for each, the end goal is to be discharged from debts and get a fresh financial start.

The Bankruptcy System

The bankruptcy system is operated by the U.S. bankruptcy courts as outlined in the U.S. Bankruptcy Code. The bankruptcy courts are sub-units of the federal district court system. As a result, there is a bankruptcy court in each federal district of the U.S. However, depending upon the population of a district, there may be multiple courthouses in different cities.

Bankruptcy Trustees

In most bankruptcy cases, a trustee is automatically appointed when the case is filed. The trustee administers the bankruptcy case by reviewing your documentation.

In a Chapter 7 bankruptcy, the trustee will attempt to sell any non-exempt property to pay creditors. In a Chapter 13 bankruptcy, the trustee will oversee the payment plan and coordinate payments to creditors. The trustee also has an obligation to watch vigilantly for fraudulent conduct and failure of the debtor to disclose information. They owe a fiduciary duty to the creditors and must collect as many assets as possible to pay them.

Protections and Discharge

Once a debtor is approved for bankruptcy, they are typically protected from creditors as long as the debtor sticks to the terms of the bankruptcy agreement. Once all terms are met, any remaining debts included in the bankruptcy filing are discharged.

A discharge is an order from the bankruptcy court permanently prohibiting any creditor from attempting to collect the discharged debt from the debtor. It's also known as a "bankruptcy injunction." The discharge only occurs after the debtor has met all of the bankruptcy agreement and payment plan terms, or the court has ruled otherwise. Those terms will vary, depending on the bankruptcy chapter.

Note

Bankruptcy will stay on your credit report for seven to 10 years, depending on the type. It can have a prolonged impact on your ability to open new credit cards or take out other loans.

Although the discharge is permanent, it is not all-inclusive. Some debts are not dischargeable. For example, most tax debts, child support, and spousal support cannot be discharged.

Types of Bankruptcy

There are six types of bankruptcy. They are known as "chapters" because they are provided for in the various chapters of the federal bankruptcy code. The most common types for consumers are chapters 7 and 13:

  • Chapter 7 liquidation is by far the most common bankruptcy chapter for individuals. It calls for the sale of a debtor's non-exempt property. The proceeds are then distributed to their creditors. Chapter 7 liquidation is appropriate for individuals who do not have a regular income and cannot or do not wish to use Chapter 13's payment plan system.
  • Chapter 13 bankruptcy is the second most common chapter for individuals. It permits a debtor with a regular income to repay at least a portion of the debt over three to five years. 
  • Chapter 11 is used by businesses to reorganize complex debt structures. 
  • Chapter 9 is used by municipalities and other political subdivisions such as utilities, hospitals, airports, or school districts.
  • Chapter 12 is for family farmers and fishers.
  • Chapter 15 is filed by foreign debtors, usually companies with bankruptcy or receivership actions pending in other countries.

Bankruptcy vs. Credit Counseling

Bankruptcy should be your last option if you face debt that has gotten out of control. There are other possibilities for dealing with debt. For example, you could talk to your creditors, and they might be able to work out a plan for you to catch up. You could also locate a credit counseling service, an organization that assists people with burdensome debt. Bankruptcy and credit counseling both have their place, so it's wise to know what each one can do for you.

 Bankruptcy Credit Counseling
Must take credit counseling before filing Voluntary unless you're planning to file for bankruptcy
Liquidates all of your assets Keep your assets 
Financially, you start over Create a debt management and financial plan
Stays on credit report for 10 years No negative credit report entries from the counseling agency
Poor credit can affect rent, loans, and purchases Helps you develop a plan to keep your credit score up

Key Takeaways

  • Bankruptcy helps an individual, family, or business discharge debts through either liquidation or a payment plan.
  • There are six different types of bankruptcy, each designed for different circumstances and with different qualifying factors.
  • The bankruptcy process can take anywhere from a few months to several years.
  • Debtors approved for bankruptcy are typically protected from creditors as long as they meet the terms of the bankruptcy agreement.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. American Bar Association. "Find Legal Help."

  2. United States Courts. "Process - Bankruptcy Basics."

  3. Federal Trade Commission. "Filing for Bankruptcy: What to Know."

  4. United States Courts. "Bankruptcy Basics," Page 5.

  5. United States Department of Justice. "Private Trustee Information."

  6. United States Courts. "Bankruptcy Basics," Pages 9–10.

  7. Experian. "How to Remove Bankruptcy From Credit Report."

  8. United States Courts. "Bankruptcy Basics."

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