What Does Bankruptcy Do?

Filing for bankruptcy can be a lifeline when facing severe financial issues. The “automatic stay” order that comes with it shields you from most creditor collection actions instantly. This benefit immediately relieves the stress and anxiety of creditor harassment, giving you much-needed breathing space.

But bankruptcy can do more than stop collections and erase qualifying debt with a “discharge” order at the end of the case. For instance, if you're a homeowner, you can save your home from foreclosure using the Chapter 13 payment plan. Car owners can also use Chapter 13 to prevent repossession.

Although bankruptcy is a powerful tool, it has limitations, and knowing them is crucial when considering whether filing for bankruptcy is the right financial strategy for you.

What Bankruptcy Can't Do

Filing for bankruptcy won’t cure all financial and legal problems. The following are some common issues you might think bankruptcy chapters 7 and 13 would resolve but won’t.

Legal Actions Bankruptcy Won’t Stop

Bankruptcy doesn’t stop all legal actions against you. The automatic stay only blocks debt collections and related lawsuits, and even then, some suits and collections will continue. For instance, filing for bankruptcy won’t stop:

• criminal cases
• most family and divorce matters (except for property division)
• collection of nondischargeable taxes, like property taxes or current income taxes
• completed foreclosures and repossessions
• completed evictions, and
• enforcement of matters concerning health and safety, like levying punishments for toxic chemical spills.

A few states allow a tenant a short period to pay back rent after a landlord receives an order of eviction from a state court or car payments to be caught up after repossession. However, those benefits are found under state law, not bankruptcy law.

Debts Bankruptcy Won’t Erase

Also, bankruptcy doesn’t eliminate all debts. Filers owing a “nondischargeable debt” will remain responsible for repaying it after a Chapter 7 case. Chapter 13 filers must pay most nondischargeable debts in full through the Chapter 13 plan, which is often expensive.

For instance, bankruptcy won’t eliminate the following debts:

• child support and alimony obligations
• student loans, except in limited circumstances
• most tax debts
• debts for personal injury or death due to intoxicated driving, and
• fines and penalties imposed as a punishment, such as traffic tickets, criminal fines, and restitution.

Filers also can’t discharge debts a bankruptcy court declares nondischargeable after a creditor's objection. Debts related to fraud and those the debtor forgot to list in the bankruptcy papers when assets were available for creditors are most likely to fall into this category. However, some courts won't discharge unlisted debts in any instance.

Collateral Bankruptcy Won’t Unencumber

If you’re wondering whether you can erase your mortgage or car loan and keep the house and car—as many do—the answer is no. Because of the lien the lender has on the property, filing for bankruptcy won’t help you keep a financed home or car free of debt.

When you agree to give a lender collateral in exchange for a loan and don’t pay, you must return the property to the lender. Bankruptcy doesn’t remove a voluntary lien given to a lender.

The same applies to home equity lines of credit, or “HELOCs,” and tax liens—you'll lose the property if you don’t pay the debt. The automatic stay will stop collection actions temporarily, but the protection won’t last long.

When you file for Chapter 7 while behind on a mortgage, car loan, or other "secured" debt or don’t propose a plan to repay what you owe in Chapter 13, the lender has recourse. It can ask the bankruptcy court to lift (remove) the stay so that the creditor can recover the property through foreclosure, repossession, or seizure.

However, a few exceptions to this rule exist in bankruptcy. You’ll have more options if the lien is a “judgment” lien or if the property is worth less than you owe. But the exceptions in bankruptcy depend on the chapter you file. Also, the rules you must satisfy are complicated, and getting the desired relief requires bankruptcy litigation. If you believe you might qualify for an exception, carefully research the requirements or speak with a bankruptcy lawyer.

Example. Amelia fell behind $6,000 on her house payment and met with a bankruptcy lawyer to see if filing for bankruptcy would help. The lawyer explained that she would need to bring the balance current before filing for Chapter 7 to keep the house from the lender. Otherwise, the lender could take steps to recover the house shortly after Amelia filed. However, she could keep the house in Chapter 13 if she could afford to pay the house payment and an additional $100 monthly for five years ($100 x 60 = $6,000), plus the trustee’s fee. The lawyer further explained that she’d need to meet other bankruptcy requirements, such as protecting home equity with a homestead exemption.

Example. When Charles filed for Chapter 7 bankruptcy, he was $3,000 behind on his car payment. The lender filed a motion asking the bankruptcy court to lift the stay so the lender could repossess the car, which the court granted.

How Bankruptcy Can Help

As soon as you file, the automatic stay prevents most creditors from initiating or continuing collection activities against you. For instance, uncompleted foreclosures, repossessions, and evictions will stop at least temporarily, along with collection lawsuits and wage garnishments.

In many cases, bankruptcy will eliminate the underlying debt the creditor is trying to collect. What you can accomplish and when the lender can resume collecting will depend on whether you file for Chapter 7 or 13 because each bankruptcy chapter solves different financial problems.

The Chapter 7 Process

Chapter 7 bankruptcy is often called “straight” or “liquidation.” Debtors don't repay creditors. The bankruptcy court discharges qualifying debts after the debtor fulfills requirements, usually four to five months after filing.

Chapter 7 Stops Creditors

Chapter 7 works wonders for stopping annoying creditor calls, letters, and collection lawsuits. Unless fraud is involved, Chapter 7 will discharge the underlying debt and eliminate the lawsuit.

Filing for Chapter 7 will also temporarily stop foreclosures, car repossessions, and evictions. However, it isn’t set up to help the debtor catch up on payments, which would be needed to resolve these situations permanently. Instead, creditors can wait until the Chapter 7 case ends to continue the action. Or, they can ask the bankruptcy court to lift the automatic stay and allow the lender to pursue the action during the Chapter 7 case—and they’re usually successful.

Chapter 13 bankruptcy is the better option for foreclosures and repossessions because the filer can use the repayment plan to make up past-due payments over time and keep the property (more below).

Chapter 13 also provides a little more help with evictions than Chapter 7 because Chapter 13 filers get a “reasonable time” to catch up on past-due rent, usually interpreted as 30 days. Only a handful of states give Chapter 7 filers a brief opportunity to catch up on rent—and again, that’s because of state laws, not bankruptcy law.

Example. Eugene filed for Chapter 7 the day before appearing in a state court eviction action. The bankruptcy filing stopped the action because the landlord hadn’t received the eviction order yet. Although the landlord eventually filed a successful motion to lift the stay, which allowed the landlord to proceed with eviction, it bought the tenant additional time in the home.

Chapter 7 Erases Debts

Filing for Chapter 7 discharges many common debts, like medical bills, personal loans, credit cards, mortgages, car loans, and more. Examples of nondischargeable debts you’ll remain responsible for include recently incurred tax debt, domestic support obligations, and student loans.

You’ll also remain liable for debts the bankruptcy court determines are nondischargeable after a creditor objects. These debts are usually related to fraud or an injury or death caused by operating a vehicle while under the influence of drugs or alcohol.

Again, it’s important to stress that you aren’t entitled to keep collateral after discharging a mortgage, car loan, or other secured agreement. You must return real estate, cars, or other financed property to the lender unless you work out an arrangement to continue paying for it and can protect its equity with a bankruptcy exemption. Learn about keeping a home in Chapter 7 bankruptcy.

Example. When Natalia filed for Chapter 7, she owed $45,000 in credit card debt, $7,000 in child support arrears, $30,000 in student loans, and $5,000 on a personal guarantee for a failed business. The Chapter 7 discharge order erased $50,000 of debt, leaving her responsible for the student loan and child support arrears.

Debtors Keep Some Property

Chapter 7 is known as liquidation bankruptcy because you turn over nonexempt property—property you can’t protect with a bankruptcy exemption—to a Chapter 7 trustee appointed by the bankruptcy court. The trustee sells the nonexempt property and distributes the proceeds to your creditors.

Chapter 13 is the better option if you’d lose property in Chapter 7 that you’d like to keep. In Chapter 13, you can pay creditors the exact amount they’d receive in Chapter 7 if the trustee were to sell the property. The best part is you get time to pay because you pay them through the Chapter 13 repayment plan.

Example. When Herman meets with a bankruptcy lawyer, he learns that his state doesn’t offer an exemption for the recreational vehicle he owns outright that’s worth $40,000. The most he can protect is $5,000 using his state’s wildcard exemption. If Herman files for Chapter 7, the trustee will sell the RV, give Herman the $5,000 exemption amount, deduct sales costs and the trustee’s fee, and distribute what remains to unsecured creditors. If Herman files for Chapter 13, he can keep the RV but must pay the equivalent of the nonexempt portion—$35,000—to creditors through the Chapter 13 plan.

Qualifying for Chapter 7

Not everyone is entitled to a Chapter 7 discharge. Your income must be low enough to pass a means test that calculates whether you can repay some of what you owe in Chapter 13. Also, you can’t have received a previous Chapter 7 discharge during the prior eight years.

Learn how often you can file for bankruptcy.

The Chapter 13 Process

Filers with higher incomes typically use Chapter 13. Although Chapter 13 takes much longer to complete than a Chapter 7 case, the plan gives filers options unavailable in Chapter 7. In most cases, Chapter 13 filers emerge from bankruptcy free from debt except for mortgage and student loan debts.

How Chapter 13 Works

A Chapter 13 filer pays creditors monthly through the Chapter 13 repayment plan. The automatic stay stops most collection activities until the bankruptcy court approves or “confirms” the debtor’s proposed Chapter 13 plan. Once approved, creditors must accept payment according to the plan terms.

A debtor’s monthly plan payment amount will depend on several factors, including the debtor’s income, expenses, debt type, and the value of any nonexempt property. After the debtor completes the plan, the bankruptcy court discharges any balances remaining on qualifying debt.

Benefits Available in Chapter 13 Only

Filers in foreclosure or facing repossession use Chapter 13 to prevent losing the property they love. The payment plan allows filers to catch up on mortgages, auto loans, and other debts secured by collateral over time. Some filers can also eliminate junior mortgages and HELOCs in a “lien strip” and reduce auto loans to the vehicle's actual value in what’s known as a “cramdown.”

Example. When Jennifer files for Chapter 13, her home is worth $350,000. However, she owes $375,000 on her primary mortgage and $25,000 to a HELOC. Because Jennifer’s home’s value is less than the first mortgage, the lien strip process will allow her to reduce the secured HELOC to an unsecured debt. Instead of paying the regular HELOC payment during Chapter 13 and remaining responsible for the balance after bankruptcy, she’ll likely pay a much smaller amount through the plan and discharge whatever remains at the end of the case.

Debts Paid in Chapter 13

In Chapter 13, filers use their money toward what they value most—saving homes and cars and paying off debts they can’t discharge in bankruptcy, like past-due child support and recently incurred tax debt. These debts are considered higher in priority than others.

Most filers pay little toward debts erased at the end of Chapter 13, like credit cards and medical bills. The exception would be when filers have significant disposable income or nonexempt property. In that situation, they'd pay more toward the debts in the lowest payment category.

Property Kept in Chapter 13

Unlike Chapter 7, filers keep all property in Chapter 13 because the Chapter 13 trustee doesn’t sell assets for the benefit of creditors. This rule doesn’t mean that Chapter 13 filers get to keep more property than filers would in Chapter 7 or that Chapter 13 creditors receive less money.

If a Chapter 13 filer owns nonexempt property—property not protected by a bankruptcy exemption—the filer must pay to keep it. The Chapter 13 filer compensates creditors the same amount they would have received had the Chapter 7 trustee sold the nonexempt property.

Example. Juliette meets with a bankruptcy lawyer and learns that her state’s motor vehicle exemption will protect only $8,000 of her car’s $18,000 equity. If Juliette files for Chapter 7, the trustee will sell the car, give her the $8,000 exemption amount, deduct sales costs and the trustee’s fee, and distribute what remains to unsecured creditors. If she files for Chapter 13, she can keep the car but must pay the equivalent of the nonexempt portion—$10,000—to creditors through the Chapter 13 plan.

How Bankruptcy Affects Credit

Filing for bankruptcy affects a filer’s credit significantly because of how long it remains on the report—up to eight years in a Chapter 7 case and ten years in Chapter 13. However, the impact lessens with time.

Also, even though most credit scores drop substantially after filing, bankruptcy eliminates debt balances, allowing the credit score to recover more quickly than it would if the debts had remained outstanding. Some people even find that their credit scores improve—however, this situation is usually limited to those who had maxed out their credit limits but weren't behind on payments before filing. Bankruptcy erases their credit balances, leaving a solid payment history in place.

After completing Chapters 7 and 13, you’ll likely receive credit card offers soon afterward. Because available credit increases a score more than most other factors—perhaps except for timely payments—you'll want to hold out for cards with higher credit limits and pay off the balance each month when possible.

How Bankruptcy Affects a Filer’s Financial Future

But those aren’t the only challenges people face after filing for bankruptcy, Chapter 7 in particular. Credit usually recovers more quickly after Chapter 13, primarily because completing a Chapter 13 plan takes three to five years.

You can anticipate a more difficult time renting or leasing housing, so securing housing before filing is crucial. Also, some banks won’t open new accounts immediately after a bankruptcy filing. And you probably won't receive favorable interest rates on large, financed purchases like automobiles until your credit score recovers.

Even so, most people find that the benefits greatly outweigh these inconveniences, especially when they're planned for before filing. Learn more about life after bankruptcy.