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The Truth About Bankruptcy

If you’re reading this, you’re probably thinking about (or in the middle of) bankruptcy. The world may tell you this route is a fresh start . . . or a horrible ending. But what’s the truth about bankruptcy?

In simple terms, bankruptcy is a legal process a person can go through to clear some of the debts they’re unable to pay.

If you’re so overwhelmed by debt that bankruptcy feels like your only option, know these three things: 1) There is hope—and you will be okay. 2) There are other options—and you should try every single one before jumping into bankruptcy. 3) Bankruptcy does not define you and will not be the end.

Keep these three things in mind as you read through the rest of this article and learn the truth about bankruptcy, including a breakdown on these specific topics:

What Is Bankruptcy?
What Are the Types of Bankruptcy?
How Does Bankruptcy Work?
What Happens if You Declare Bankruptcy?
What Are the Consequences of Declaring Bankruptcy?
Should You Declare Bankruptcy?
What Are Alternatives to Filing for Bankruptcy?

What Is Bankruptcy?

Bankruptcy is a court proceeding where you tell a judge you can’t pay your debts. The judge and court trustee look through your assets and liabilities (aka what you own and what you owe) to decide whether to discharge (or cancel) some of your debts. If the court finds that you really have no means to pay back your debt, you’ll go through the official process of declaring bankruptcy.

A Quick History of Bankruptcy

The term bankruptcy probably came from the Italian phrase banca rotta—which literally means broken bench—because in medieval days, if a merchant couldn’t pay their creditors, they could come break the merchant’s market stall (or bench).1

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What about bankruptcy in America, specifically? Well, several different bankruptcy acts popped up during times of economic crisis before the Bankruptcy Act of 1898. This one said bankruptcy didn’t require the creditor’s approval and stuck around until the Bankruptcy Reform Act of 1978—which set the laws we follow today.

Now when you file for bankruptcy, no one’s coming to smash your bench (thank goodness!), but it’s still a painful experience.

What Are the Types of Bankruptcy?

There are six different types of bankruptcy

Chapter 13 Bankruptcy

Chapter 13 is a bankruptcy method for individuals where the court approves a plan for you to repay some or all of your debts over three to five years. You get to keep your assets and you’re given time to bring your mortgage up to date. You agree to a monthly payment plan and have to follow a strict budget monitored by the court. (There’s no privacy in bankruptcy.)

People can file for Chapter 13 bankruptcy if their unsecured debt is less than $419,275 and their secured debt is less than $1,257,850.2 

Chapter 7 Bankruptcy

Chapter 7 bankruptcy is the most common type for individuals. In this case, the court sells all your assets—with some exceptions—so you can pay back as much debt as possible. The remaining unpaid debt is usually erased.

You could lose your home (or the equity you’ve put into it) and your car in the process, depending on what the court decides. There’s no set amount of debt you need to qualify—the court just has to decide you don’t make enough money to pay off your debt.

Chapter 11 Bankruptcy

Usually just for businesses, Chapter 11 creates a plan for how the business will still run while paying off all their debt.

Chapter 12 Bankruptcy

Chapter 12 bankruptcy allows farmers and fishermen to get on a payment plan for their debts to avoid foreclosure on their property.

Chapter 15 Bankruptcy

International bankruptcy cases are handled in Chapter 15.

Chapter 9 Bankruptcy

Chapter 9 bankruptcy is a repayment plan for towns, cities, schools and the like to pay back their debt.

P.S. For specific information about bankruptcy laws in your area, visit the United States Courts website. There you’ll find info on the process and where to find help in your area. There’s a bankruptcy court for each judicial district in the United States—90 districts in all.

How Does Bankruptcy Work

You’ll see this theme throughout this entire article: bankruptcy sucks. If you can avoid it, avoid it. (See the What Are Alternatives for Declaring Bankruptcy section for practical ways to do just that.) But if you do everything possible to avoid bankruptcy and still come to that point, here’s a quick overview of how to file for bankruptcy and the paperwork you’ll need to get ready.

How to File for Bankruptcy

  1. Figure out which type of bankruptcy to file for.
  2. Gather and organize the necessary documents (listed below).
  3. Take a credit counseling course.
  4. Fill out your bankruptcy paperwork.
  5. Make sure you have your fees (for an attorney and filing).
  6. Print your bankruptcy paperwork.
  7. File your bankruptcy paperwork.
  8. Send all the necessary documents to your bankruptcy trustee (the person appointed by the court to handle your case).
  9. Meet with this trustee in a 341 meeting (or a meeting of the creditors).
  10. Take a debtor education course.
  11. Finish the bankruptcy process (which varies based on the type of bankruptcy you filed for).
  12. Rebuild your life and know you can rise from this situation!

Yeah—it's going to feel like you're digging up and showing off every bit of private information you've ever had. Really, the only upside is they don’t ask for that awkward eighth grade yearbook photo.

What Documents Do You Need to File for Bankruptcy?

There’s a heck of a lot of paperwork and forms and documents involved in bankruptcy, but let’s talk about what you need to gather up at the start:

  • Tax returns for the past two years (for Chapter 7) or four years (for Chapter 13)
  • Income documents (such as pay stubs from the past six months, your past two W-2s, and proof of any extra income sources like rental properties or Social Security)
  • Mortgage information (like an appraisal, mortgage payment statements, and maybe the deed of trust and proof of home insurance)
  • Vehicle information (such as proof of your vehicle’s value, any car loan statements, and maybe a copy of your registration and proof of car insurance)
  • Retirement information
  • Bank account statements
  • Identification (meaning your valid photo ID and proof of your Social Security number)
  • Other documentation showing any other debts or expenses, like alimony or child support

Yes, that’s a lot. Bankruptcy is not an easy out! Also, your particular state or court system may require more. Get ready to do a lot of hunting and have a lot of patience here.

What Happens if You Declare Bankruptcy?

If you declare bankruptcy, creditors have to stop any effort to collect money from you, at least temporarily. Most creditors can’t write, call or sue you after you’ve filed. But even if you declare bankruptcy, the courts can require you to pay back certain debts. Each bankruptcy case is unique, and only a court can decide the details of your own bankruptcy.

Let’s talk for a moment about what bankruptcy does and doesn’t cover:

What Does Bankruptcy Cover?

Bankruptcy can stop foreclosure on your home, repossession of property, or garnishment of your wages. (Garnishment is when the court orders part of your paycheck to be sent directly to your creditor—without you ever seeing the money). Bankruptcy cancels many—but not all—of your debts.

What Is Not Covered by Bankruptcy?

  • Student loans
  • Government debts like taxes, fines or penalties
  • Child support and alimony
  • Expensive items purchased right before filing bankruptcy, like cars, boats or jewelry

What Are the Consequences of Declaring Bankruptcy?

Let’s not sugarcoat it: Bankruptcy takes a huge emotional toll on a person. It ranks up there with divorce, loss of a loved one, and business failure. Beyond the emotional impact, here are other effects of declaring bankruptcy:

Your bankruptcy becomes public domain.

This means your name and other personal information will appear in court records for the public to access. That’s right . . . Potential employers, banks, clients and businesses can access the details of your bankruptcy.

Filing bankruptcy is expensive.

Filing fees for Chapter 13 bankruptcy will cost around $310 plus attorney fees, which can be anywhere from $3,000 to $3,000. For a Chapter 7 bankruptcy, you’ll shell out $335 for filing fees and $1,500 to $3,000 for an attorney.3

Buying a home can be more complicated after a bankruptcy.

Unless you pay cash for a home, it could take one to four years before you qualify for a mortgage loan.4

Bankruptcy affects your credit score.

We aren’t pro-credit scores, but it’s important for you to know a bankruptcy dings your FICO. Hard. And that ding lingers. Chapter 13 bankruptcies stay on your credit report for about seven years, and Chapter 7 stays on there for 10 years.

Bankruptcy doesn’t clear all debts.

We’ve touched on this some, but declaring bankruptcy doesn’t make all your problems go away—and it doesn’t even make all your debt go away. Most student loans, alimony, child support, any reaffirmed debt, unpaid taxes, government debts or court fines aren’t cleared in a bankruptcy.

Should You Declare Bankruptcy?

Listen. We’ve said it before, and we’ll say it again: Bankruptcy should be your very last option. Check out all the alternatives (aka how to avoid bankruptcy) below. Try each and every one. If nothing works, and you’re still so overwhelmingly underwater that you simply cannot swim—then and only then do you declare bankruptcy.

What Are Alternatives to Filing for Bankruptcy

Before you even start gathering up that giant pile of documents you need to file for bankruptcy, go through this list of alternatives:

Get on a budget.

Budgeting may seem intimidating, but it’s just a plan for your money. And if you’re planning to get out of debt and avoid bankruptcy, you can’t do it without a budget. You need to see exactly what money you have coming in and where all of it is going.

Once you see what your money is doing, you can start telling it what you want it to do. And what you want is to have more money freed up to pay off that debt.

That means cutting extras and spending less money. That means learning tips on how to save money on everything. That means being super intentional with every single dollar you make and spend.

Yes, it’s work. But it could be the exact thing that keeps you from bankruptcy. Don’t. Skip. This.

Cover your Four Walls.

When you’re making a budget that will work for you right now, where do you start? What’s the main stuff you need to focus on covering? Start with what we call your Four Walls: food, utilities, shelter and transportation. These are the main essentials.

Keep everyone fed, the lights on, a roof over your heads, and gas in the car to get to work. If these Four Walls are only things you can pay for while you’re getting out of debt, that’s called survival mode, and that may be what you need to jump into right now.

Sell. Everything. You. Can.

Here’s the deal: If you declare bankruptcy, you’re probably going to lose some of your stuff anyway. So right now, sell everything you can. Be the one in charge of what goes and what happens to the money coming in from those sales. Put all of that money straight toward your debt.

Talk to a financial coach.

You don’t have to walk this alone. Read that again: You don’t have to walk this alone. Get with a financial coach and talk about your situation. They aren’t here to judge—they’re here to help.

A financial coach can help you figure out a personalized plan of action for your specific situation. And yes, talking about money can be terrifying, but if you declare bankruptcy, your financial privacy will be out the window immediately. Opening up to a trustworthy financial coach now can help you avoid having to open up to a whole courtroom of people in bankruptcy.

Create extra income.

Another way to avoid bankruptcy is to bring in more money. Get yourself a side hustle. There are plenty of ways to work extra hours that fit into your schedule, and also plenty of work-from-home jobs that will keep you from spending extra drive time or gas money.

You’ll be busy. But this is for a season—and if you’re on the verge of bankruptcy, you’re at war right now. A war against your debt. The good news is, you know who wins. You. Even if you try every single alternative on this list and still can’t fight off bankruptcy, you are not defeated.

Hey. We don’t say this lightly: Bankruptcy sucks. We know. We also know you can rise above.

Learn how in Financial Peace University—available only in Ramsey+. The teachings in FPU started as conversations over coffee. People struggling with their finances wanted to hear from Dave Ramsey—to get hope from his story of hitting rock bottom and digging his way out again. Those conversations eventually turned into our bestselling money course that’s been helping people learn how to pay off debt, budget and build wealth for over 25 years. No matter their income. No matter their past.

Try it out in a Ramsey+ free trial. Spend the time of that free trial listening to Dave’s story, learning how to get out of this debt, and believing you can get through this—bankruptcy or no bankruptcy. Because you can. And you will.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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