Is Chapter 7 Bankruptcy the Right Choice for You?

What is Chapter 7 Bankruptcy?

Chapter 7 bankruptcy is a legal proceeding under the Federal Bankruptcy Code where the debtor seeks relief from his or her debts. Under Chapter 7 proceedings, the debtor must turn over all his or her nonexempt property (which in most cases, doesn’t amount to much) over to a court appointed trustee who then sells the property and distributes an equal share to the debtor’s creditors. In return, the debtor typically has all outstanding debts forgiven (with a few important exceptions which are noted later).

To qualify for Chapter 7, the debtor must be unable to realistically pay off the debts that are owed. If the debtor has enough stable income to pay a significant portion of the debts owed, he or she may not qualify for relief under Chapter 7. In this case a Chapter 13 bankruptcy is a better option. For more information on Chapter 13, see the section entitled “Would Chapter 13 Bankruptcy be a Better Option?” below.

If the debtor qualifies, Chapter 7 bankruptcy is probably the most cost effective, efficient and simple method for dealing with unmanageable debt. To determine whether you should consider Chapter 7 bankruptcy, ask yourself the following questions:

Can I afford the negative marks on my credit rating?

It is a common misconception that bankruptcy ruins your credit rating, which therefore ruins your chances of ever borrowing money again. This is simply not true. You can borrow money after bankruptcy, and filing for bankruptcy can actually make you more attractive to lenders, not less.

Unquestionably, bankruptcy puts a negative mark on your credit report, which can remain there up to ten years. Lenders will have access to this report, and it may cause them to deny you a loan.

But what you need to ask yourself is “how bad is the damage really?” The unpleasant truth is that if you’re seriously considering bankruptcy, chances are that your credit rating is already in poor shape. In this case, filing for bankruptcy is unlikely to make a significant impact on your overall credit profile.

In fact, bankruptcy may even help your profile for future lending. Creditors know that once you’ve filed for bankruptcy, much of your debt burden is relieved. This means you will have more available cash to pay them! Furthermore, once you’ve filed for Chapter 7 bankruptcy, you will not be allowed to file for another Chapter 7 for eight years. Therefore, many creditors will actually consider you to be a better lending risk than you were before filing for bankruptcy! In this sense, bankruptcy may actually make it easier for you to borrow in the future than it is now.

In any case, you’ll find that bankruptcy absolutely does not ruin your chances of ever borrowing money again. In fact, the first piece of mail you receive after bankruptcy will likely be a credit card offer! Not that I’d recommend accepting, of course …

How much money can my creditors really seize from me?

There’s an old saying that you can’t squeeze blood from a stone. In law, this concept is recognized as being “judgment proof.” Essentially, all this means is that an individual has so few assets that there is nothing left for a creditor to take. When you are judgment proof, even if your creditors do win a favorable judgment in court, they will not be allowed to take anything from you. Various laws prevent creditors from further impoverishing individuals who fall below a certain level of income.

Being judgment proof does not mean that the debts go away! A judgment proof individual still has a future obligation to pay the debt. If such an individual were to suddenly acquire the money to pay the debt, the creditor could then take action to collect.

How much of my debt is dischargeable?

Not all debts can be forgiven in Chapter 7 bankruptcy. In many cases, tax liability and student loan debts cannot be discharged in bankruptcy. Alimony and child support obligations also typically survive a bankruptcy.

Be aware also that any debts incurred by defrauding creditors will likely not be dischargeable in bankruptcy either.

You also need to consider how much of your debt is “secured debt.” Secured debt is when the creditor reserves a right to seize a designated part of your property if you default on your payments. Common examples are home mortgages and car loans. Often major retailers will include security agreements on in-store credit cards which allow them to repossess the items you buy at their store, if purchased with the card.

If a debt is secured, Chapter 7 bankruptcy can relieve you of the obligation to pay the rest of what you owe to your creditor. However, the creditor still retains the right to seize the property described in the agreement. In other words, the bank can still take away the car, or seize the house. This doesn’t mean that you will automatically lose your house if you file for Chapter 7. But it does mean that additional steps need to be taken to protect your assets if they secure a debt.

Usually, a good bankruptcy attorney can help you keep your house or other property even in Chapter 7. But there are instances where this may not be feasible. In such instances, it may be better to consider other alternatives.

What will happen to my co-signors?

Even if you successfully complete a Chapter 7 bankruptcy, that doesn’t let your co-signors off the hook. They will likely remain liable for the entire amount of money. If you wish to protect such co-signors, bankruptcy may not be the best option.

Note also, that you need to be very careful to assure that your spouse is not still liable once your debts are discharged. You may both need to file for bankruptcy.

Are there urgent circumstances, such as a home foreclosure, that require a bankruptcy filing?

When you file for bankruptcy, the court places an “automatic stay” on all of your debts and property. This stay essentially forces all credit collection activity to halt until the bankruptcy court sorts out your case. This stay can buy you some much-needed breathing space to sort things out without creditors harassing you (creditors generally aren’t even allowed to contact you during the stay either).

In particular, filing for bankruptcy freezes any foreclosure proceedings that have been brought against your house or other property. You’ll need a competent attorney to determine whether you can save the house or not in bankruptcy, but at least filing can give you some vital time to try and protect your assets.

Can I realistically pay my debts?

Bankruptcy is not meant for simply avoiding bills you don’t want to pay. You must really be unable to get ahead on your debt load.

When full payment is not impossible, other options should be considered. You can always negotiate directly with your creditors to rearrange your payment plan. A creditor may even agree to reduce the amount of money you owe.

If the idea of negotiating with hostile creditors doesn’t appeal to you, “debt counseling agencies” will often agree to handle the negotiations for you.

Warning: Be extremely careful here! This is a vulnerable time for you, and many individuals out there would like to exploit that weakness. There is a lot of fraud occurring in the credit counseling area and not all self-described counseling agencies are legitimate.

The US Trustee’s Office maintains a list approved counseling agencies, which you should consult. But be aware that it is impossible for the Trustee’s office to keep track of all the bad apples. So the fact that an agency is listed on the Trustee website does not guarantee the agency’s honesty or competence.

Don’t be fooled by the fact that an agency is listed as a “non-profit” either. Even an agency labeled as a “nonprofit” may be getting significant payments and financial kickbacks from credit card companies and other large commercial lenders. If you use a credit counseling service, realize that the advice you are getting may not be entirely unbiased. The label of “nonprofit” has nothing to do with the agency’s competence or honesty. Federal law currently allows credit counselors to use the label of “non-profit,” but the word says nothing about the agencies’ objectivity.

Even if the agency is legitimate, they may charge excessive fees for doing things that you could easily do yourself. Many will claim to have “special influence” with creditors or claim that they “know how to deal with creditors.” Often, such statements are greatly exaggerated or simply not true.

Would Chapter 13 Bankruptcy be a better option?

Two forms of bankruptcy are available to typical consumers: Chapter 7 and Chapter 13. The essential difference is that while Chapter 7 completely removes the obligation to pay for certain debts, Chapter 13 simply renegotiates the payment plan.

In Chapter 13, you and your creditors negotiate a new payment plan under the supervision of the bankruptcy court. Often this repayment plan will be for a smaller amount than you originally owed to your creditors. Any debt not included in the payment plan is then erased.

There are many reasons why Chapter 13 may be more attractive to you. Here are a few possibilities:

1. You wish to avoid a foreclosure on your home, or seizure of secured property.
2. To prevent a co-signor on your debt from becoming liable for the entire amount.
3. You own your house and don’t want it to be sold by the federal bankruptcy trustee.
4. Your income is too high to qualify for Chapter 7.
5. You already filed for Chapter 7 in the past eight years. By law, you may not file another Chapter 7 within eight years of a previous filing.

Be aware that Chapter 13 bankruptcy is almost always available to you, even if you already filed for a Chapter 7 bankruptcy recently.

What about that new law that was passed in 2005? Doesn’t it get rid of Chapter 7 as an option?

In short – no. The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) went into effect on October 17, 2005. What the law does is:

1. Impose stricter documentation requirements on debtors who wish to file for Chapter 7;
2. Provide some new formulas for determining whether a debtor qualifies for Chapter 7; and
3. Require that all debtors receive credit counseling at an approved debt counseling agency.

It is important to note that you must complete a certified debt counseling course before filing for bankruptcy. These courses run about $50 (although the counseling agency is required to offer the course for free if you show extraordinary economic hardship) and take about an hour. Be aware that courts have been interpreting this counseling requirement very strictly and aren’t accepting most excuses for not attending.

The second major change is that the new law imposes a “Means Test” on all Chapter 7 filers. In essence, the Means Test simply means that if your real income is greater than your state’s median income level, you cannot file for Chapter 7 bankruptcy and must file for Chapter 13 instead. Of course it is much more complex than that, but your bankruptcy attorney can make all the necessary calculations to see if your income level qualifies you for Chapter 7 bankruptcy.

Contrary to media hype, most debtors who are filing for bankruptcy in good faith are going to pass this test. Some experts say that as many as 70 percent of Chapter 7 filers will be able to pass the means test and have their debts discharged.

There has been a lot of panic and media spin about this new law. But contrary to popular opinion, it does not “take away” Chapter 7. It makes Chapter 7 filings more complex and difficult, but Chapter 7 Bankruptcy is still a real option for you.

However, the increased complexity of the new Chapter 7 bankruptcy process makes it more important than ever to have competent legal assistance to guide you through this process.