What Is Bankruptcy?

Bankruptcy is a legal proceeding available to folks who can't find another way to pay their bills and satisfy their creditors. It's a last resort, since it goes on your credit report for 10 years, reduces your credit score and cuts your access to credit. You declare bankruptcy in court with the assistance of a lawyer who has the required expertise.

How Bankruptcy Works

A primary goal of bankruptcy laws is to give debtors a financial fresh start. A debtor petitions the federal district bankruptcy court for a "discharge," or removal, of debts, although the debtor seldom has to appear in court. However, debtors must attend a formal meeting of creditors -- known as a "341 meeting" -- supervised by a court trustee. According to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, debtors must document their efforts to receive credit counseling and must meet certain state-based income tests.

Bankruptcy Chapters

Personal bankruptcies are available in three types, or "chapters": • Chapter 7 (Liquidation) -- a trustee cashes in the debtor's assets and distributes the cash to creditors in an orderly fashion. Chapter 7 is not available to debtors with income exceeding certain thresholds. In this case, the debtor turns to Chapter 13. • Chapter 13 (Adjustment of debts of an individual with regular income) -- for debtors with regular income who wish to hold on to valuable assets, such as a house. Under this chapter, a debtor works out a long-term repayment plan with creditors. • Chapter 11 (Reorganization) -- usually reserved for businesses, this chapter also applies to debtors who owe more than $1.2 million. Under Chapter 11, the debtor must repay some debts and receives discharge on some debts.

Chapter 7 Predominates

According to the Administrative Office of the U.S. Courts, 1.039 million debtors filed for personal bankruptcy in 2013, of which approximately 68 percent were Chapter 7. Most Chapter 7 filings involve debtors who own few or no assets and have amassed significant unsecured debt -- that is, debt without collateral. Under Chapter 7, the debtor must show why no other reasonable alternative is available. The Chapter 7 means test compares the debtor's income to the median income in the debtor's home state. If income exceeds the median and the debtor can repay even a minimal amount, the case is converted to Chapter 13. The court uses the Internal Revenue Code to calculate the reasonableness of living expense deductions from the debtor's income. The 2005 Bankruptcy Abuse Act prevents debtors from linking multiple Chapter 7 filings to gain access to a Chapter 13 bankruptcy.

Preventing Bankruptcy

You might be able to avoid bankruptcy if you carefully monitor and control your use of debt. Quicken offers a tool called a Debt Reduction Plan that creates a schedule to efficiently pay down your debt. The tool optimizes the payment schedule to reduce the highest-interest-rate debt first and minimize the time it takes you to emerge from debt. The tool scans the loan and credit card accounts you've put into Quicken and allows you to include or exclude each debt from the plan. You then enter any missing details, such as interest rates and minimum required payments, and enter the total you want to pay each month. The plan then calculates an optimal repayment schedule.

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