How Does Bankruptcy Work?

by Meredyth Glass ; Updated July 27, 2017

Bankruptcy laws serve to protect you from crippling debt and allow you to start over. But the process has limits and rules to ensure that judgments consider your creditors as well. Understanding how the process works will help you know which questions to ask before you decide if bankruptcy is the best course.

Automatic Stay

Once you've filed for bankruptcy, almost all collection efforts must stop. This stops the phone calls, and it will keep your utilities from being shut off for several weeks and stop foreclosure and repossession efforts pending the completion of your bankruptcy. However, experts such as attorney Stephen Elias, president of the National Banrkruptcy Law Project until his death in 2011, warn of some exceptions. For example, priority debts, such as those for child support payments or taxes, are not alleviated by bankruptcy and the stay doesn't apply to them. And creditors can petition the judge to override the stay in certain situations.

The Means Test

The first thing the bankruptcy team will do is assess your ability to pay. To determine this, a judge will first compare your income over the last six months with the median income in your state for a family of equal size. If your income is equal to or less than the median income, you can file for Chapter 7.

Should you not clearly qualify for Chapter 7, the judge will ask for a means test that more closely examines your assets and income. Should the results indicate you have some disposable income, you may qualify for a Chapter 13 reorganization plan. Chapter 13 bankruptcy allows you to keep more of your property, but it also requires you to pay back more of your debts.

How Creditors Are Paid

Under Chapter 7, creditors are paid via the liquidation of your estate. You will need to provide the court with a full list of your assets, and the judge will compare that with the list of allowed exemptions in your state. Most states allow exemptions for a home and vehicle and some personal property, such as clothes and furniture. You can also choose to use the federal guidelines if those allow you to keep more than the exemptions in your state. Should your home or vehicle be valued at more than the allowed exemption, your property will be sold so the amount over the exempted amount can be applied to your debts.

Under a Chapter 13 bankruptcy, your creditors are paid via a three- to five-year payment plan determined by the judge and monitored by a court-appointed trustee. Once the means test has been applied to your financial situation, all of the identified disposable income will be applied to your payment plan. Each month during your payment plan you must pay the trustee a fixed sum agreed to in your settlement. That sum will be divided between your creditors in a prearranged manner, according to the priority of the debt.

Prioritization

No matter which bankruptcy type you file for, Elias noted that the courts will prioritize your debts. Should you qualify for a Chapter 13 bankruptcy, you might keep more of your property, but you will be required to pay at least as much on each debt as the creditor would have received under Chapter 7.

Priority debts must be paid in full and will not be forgiven or discharged by bankruptcy.

Secured debts have collateral attached. These include mortgages and car payments. The courts place a second priority on these debts and typically require them to be liquidated or paid in full. Should you decide to keep your house or car, you may be able to negotiate the repayment of missed payments, but you will be required to keep current after that. Mortgages, for example, are typically carried forward so the debt outlives your bankruptcy.

Unsecured debts, such as credit card balances and medical bills, are last in line. Any disposable income or money from the sale of property that remains after the priority and secured debts are paid is divided to pay for unsecured debt.

About the Author

Meredyth Glass has been writing for educational institutions since 1995. She contributes to eHow in the areas of parenting, child development, language and social skill development and the importance of play. She holds a Master of Science in speech, language pathology from California State University, Northridge and a Bachelor of Arts in anthropology from California State University, Northridge.