We’re all faintly aware that when you’re out on your ass and the bills are piling up, bankruptcy is an option for escaping the mountain of debt. But how does it work? What are the pros and cons? And does it really get you off the hook?
Let’s find out.
What exactly is bankruptcy, anyway?
The simplest way to describe bankruptcy is the ability to legally get out from under debt when you don’t have enough assets to cover those debts. It gives a person (or a business) the chance to start fresh, with a clean slate. It’s the legal equivalent of a mulligan in golf, and allows you to gradually pay off your debts — often for far less money — and eventually emerge debt-free.
That sounds… okay? I thought bankruptcy sucks to go through?
It kinda does. Seth Kaplowitz, an attorney and professor of finance and management at San Diego State University, says to think of it as a person’s least-worst option. There is, of course, a stigma attached to bankruptcy — you may not be eligible for certain jobs (especially if you’re handling money); your credit rating will be in the toilet for a while; any loan offers you get will have high-interest rates; many (but not all) of your assets will be taken away; and of course, it involves lawyers and court, and no one ever visits those for fun.
So when should someone declare bankruptcy?
“It depends on everybody’s appetite for stress,” Kaplowitz says. “If you can weather the storm with collection agencies calling all hours of the day and night, and basically having your interest on your credit card debt skyrocket, then you can hold out for a long period of time. But most of the time, when people realize that there’s just no way that they make enough money or have enough savings to settle their debts, that’s when they pull the trigger.”
So how does it work?
You’ve probably heard of Chapter 11, Chapter 13, Chapter this-and-that. They’re all different kinds of bankruptcy: Chapter 7 is when you face a near-total liquidation of your assets (with some protections — more on those later). Chapter 11 is for businesses, kind of like a reorganization that stops all collections and gives the petitioner some breathing room, and usually reduces the debt in the end. Then there’s Chapter 13, for individuals, which gives them some breathing room and helps them reorganize their debt, usually at a certain number of cents on the dollar.
What’s up with Chapters 1–6?
They don’t exist. But there is a Chapter 12 — it’s for farmers and fishermen, so never mind that one for now.
So what kinds of protections do you get when you file for bankruptcy?
Essentially, personal bankruptcy doesn’t take you all the way down to the ground. “It takes you to hovering just above it,” Kaplowitz says. So, you can’t lose your car, since you need to be able to go to work. You can’t lose your house, or any tools you need for your trade. You don’t have to give up all your jewelry, or things like family heirlooms. Basically, you can keep what you need to get back on your feet and avoid losing all your dignity. But you can say goodbye to most everything else of value.
Again, that sounds… not as bad as I thought? How does the process work?
The first thing you’d do is find someone who knows what they’re doing — i.e., a bankruptcy attorney. First, they’ll tell you whether you can file for bankruptcy.
Why wouldn’t you be able to?
If you make too much money in comparison to the debts you have, you may not actually qualify. It’s called the “means test” — that is, do you have the means to pay off these debts?
Say I don’t, what then?
Then the attorney will tell you that you have to pass a credit counseling exam — it’s a bit like traffic school, and it’s mandated by bankruptcy court. There’s one test at the start and one at the end of the bankruptcy process. It’s pretty basic information — telling you to use your check ledger and not a bank statement to see how much you have in your account, and basically, like, don’t spend more than you earn, dummy. Create a budget and live by it, etc.
Then the attorney will file a petition for bankruptcy in federal bankruptcy court. Immediately upon filing, a stay goes into effect, and all your creditors are notified that you’re declaring bankruptcy. Here’s where it gets interesting: A federal bankruptcy trustee takes control, and to you and your creditors, this person is basically God. “Whatever the trustee says, goes,” Kaplowitz says. “They can make your life miserable.” If they don’t believe you’re being totally honest about everything you’re telling them and about all the things you own, the process will be torturous. They can make you go chase documentation that may not exist, or tie up all your time in other excruciating ways.
Likewise, for creditors, trustees often make make offers they can’t refuse (“Take this, or get nothing”). They approve or deny everything, for both sides. Then there’s a creditor’s meeting to figure out who’s owed what. Next, the trustee will interview you and review your petition, to make sure you have no assets you’re trying to hide.
What if you’re unable to make payments to everyone you owe money to?
That’s where the trustee comes in. They have the power to force a creditor to take a deal. Again, according to Kaplowitz, the trustee has enormous power, and they’re the ones who work out deals with all your creditors on what you owe them.
How long do you have to pay these people off?
You don’t get forever — usually it’s within a relatively short time period, like five years.
Do you have to pay something to everyone you owe money to?
No — here’s where there’s a big difference between secured and unsecured creditors. Secured creditors are usually car loan and mortgage companies. In other words, they’re the ones holding on to the actual title of your car or home until you pay off your loan, so you’ll be owing them some money. In contrast, credit card companies (unsecured creditors) often end up getting screwed. A trustee may work out a deal based on your situation where you don’t owe them any money at all. That’s partly why these companies charge such high-interest rates to everybody, because they often take a hit in bankruptcy court.
How long does bankruptcy last?
After seven years, your bankruptcy history will be wiped off of your credit score — and your score will usually climb higher, because it shows that you did something about your debt.
So in a way, are you better off declaring bankruptcy than doing everything you can to pay off your debts?
According to Kaplowitz, every situation is unique. Generally speaking, though, if you’re somehow able to dig yourself out of debt without declaring bankruptcy, your credit score probably will be better — and you’ll still have all your toys and trinkets that would otherwise have been seized in a bankruptcy. Paying down debts and high-interest rates can be expensive, though, so declaring bankruptcy is usually a much cheaper option.
You sometimes hear about people abusing bankruptcy, how does that work?
Imagine you’re rich, but you owe a lot of money — for example, you have debts totaling $3 million, and your assets total exactly $3 million. It wouldn’t be unheard of for someone to try and squirrel away $2.5 million and try and pay off their creditors with $500,000.
That’s one of those “frowned upon” things, right?
Oh yeah. Bankruptcy fraud is serious. Usually it involves hidden assets, which are known as “preferential transfers” — that’s when someone, say, loans his boat to his brother on the understanding that he’ll get it back one day, hides money overseas or isn’t honest with the bankruptcy court about everything they own. If the court finds out you were cheating, it’ll unwind the entire bankruptcy, and you’d be looking at jail time.
Bankruptcy fraud is a felony, so you could be facing several years in an orange jumpsuit. This is white-collar crime though — you won’t be in a Supermax prison with terrorists and serial killers. More like Club Fed.
So in the grand scheme of things, it’s not so bad?
Eh… “You really don’t want to go down that road,” Kaplowitz says. Just play by the rules. “If you follow the procedure, it’s a very straightforward process,” he says. “If you decide you want to run from first to third without touching second, you’re gonna have a problem.”
Donald Trump declared bankruptcy six times, right? What’s up with that?
Well, he didn’t personally declare it all those times — it was for different entities he owned (like casinos, which, admittedly, are generally cash cows in the hands of competent managers). As he’s stated, these were all perfectly legal, although to the millions of people who live paycheck-to-paycheck, it’s not a good look for someone who’s six-times bankrupt (or at least, the companies he owns) to fly around in a jet with his name on it and brag about how much money he has.
So bankruptcy is, overall, a good thing?
Kaplowitz thinks so. “Bankruptcy is a gift in the law to help people who’ve gotten themselves jammed up,” he says. “The country that we came from, England, had debtors prisons. Bankruptcy is a way to get people to be participating members of the economy and avoid putting people in jail for owing other people money.”
When you put it that way, yeah, bankruptcy sounds way better. Think of it as a do-over when you’ve fucked up, or have gotten walloped by major economic forces (like recessions). It’s there to get you back on your feet, but it comes at a price — and several years of atonement.