Bankruptcy: What it is, how it works, types, and consequences

The game of life is full of so many ups. But life wouldn't be life without a few downs, too. Most of us face financial ups and downs, but some circumstances may call for more significant action. Things like losing a job, divorce, or a medical emergency can leave you with mounting debt. And this can happen to anyone, even if you're someone who keeps all their financial 🦆🦆🦆in a row.

Bankruptcy gets a bad rap, but it is a viable option for some. Let's explore how it works and what to know about it. 

What is bankruptcy?

Bankruptcy is a legal process that people and businesses use when they have trouble repaying significant debts. There are several different types of bankruptcy, which we'll cover shortly. It’s a complex process that can make you debt free or provide a repayment plan that better fits your financial circumstances.

Pros and cons of bankruptcy

While bankruptcy can sound pretty enticing — who wouldn't want to say adiós to that 10-year-old, 30% APR debt? — it has its benefits and drawbacks. 

Be a financially smart family!

Be a financially smart family!

From saving for the future to understanding credit, see how families are thriving with Greenlight.

Try Greenlight today

One obvious pro is relief from bills you're struggling to pay. If you're in a mountain of debt and can't make your payments, declaring bankruptcy can be a relief. And since federal law allows you to exempt some of your assets, you may be able to keep your home, car, and other valuable items.

However, bankruptcy does a real number on your credit. It's hard to qualify for a loan or credit card after a bankruptcy. And since it stays on your credit report for up to 10 years, your credit score may suffer. It's also not cheap — you'll pay for court costs and may need an attorney to guide you.

Types of bankruptcy

There is more than one type of bankruptcy. Individuals use Chapter 7 or 13. Chapter 11 is usually best for businesses.

What is Chapter 7 bankruptcy?

A Chapter 7 bankruptcy eliminates most unsecured debts. Unsecured debt is any type of loan not backed by collateral, such as credit cards, personal loans, and medical debt. The court will use your non-exempt assets to pay creditors before closing out the remaining debts. To qualify for a Chapter 7 bankruptcy, you must meet several eligibility requirements, like income limits or the means test. 

What is Chapter 13 bankruptcy?

Chapter 13 bankruptcy establishes a payment plan for debtors to repay their creditors. The payment plan usually lasts three to five years and is made to fit your financial situation. It’s most commonly used by people who don’t qualify for Chapter 7 bankruptcy because they don’t meet the eligibility requirements. In a Chapter 13 bankruptcy, the court may allow you to keep your home, car, investments, and other assets.  

What is Chapter 11 bankruptcy?

Struggling businesses may find a Chapter 11 bankruptcy allows them to reorganize for profitability while continuing operations. During a Chapter 11 bankruptcy, the court establishes a debt repayment plan for the organization to follow.  

How does bankruptcy work?

Bankruptcy is a process that can take some time to work through and may be best navigated with an attorney. There are five basic steps involved.

1. Declaring financial distress

The first step is recognizing that you're in financial distress and don't have a way out. Financial distress means you can no longer pay your debts. That’s different from running a little short on money for the month. You don’t have a resolution for repayment, and you need help. 

2. Filing for bankruptcy

Officially declaring bankruptcy is a legal process, so it’s advisable to work with an experienced attorney. While you can self-file a bankruptcy petition, there's a lot of room for error. You don't want to risk mistakes that lengthen the process.

3. Meeting with a bankruptcy trustee or attorney

In this stage, a bankruptcy trustee or attorney reviews your assets and debts. They'll examine what you own and determine what's exempt. They may recommend selling assets to cover existing debts if you have any. The trustee or attorney may also help with repayment plans for Chapter 11 and 13 bankruptcies.

4. Going through the bankruptcy process

After filing for bankruptcy and meeting with the trustee or attorney, you'll appear before a judge in federal bankruptcy court. The judge will review the case and make a decision. 

5. Discharging debts or reorganizing debt payments

Under a Chapter 7 bankruptcy, the judge may discharge your debts. That means you may be released from repaying some or all of them. In a Chapter 11 or 13 bankruptcy, debt discharge doesn't happen until you complete your obligations under the repayment plan.

Considerations before filing for bankruptcy

Bankruptcy isn't for everyone. Some debt relief options may be a better fit. You might try negotiating with creditors yourself. If you explain your situation, they may be willing to lower your payments or interest rate. Another alternative is debt consolidation, in which you take out a loan to repay outstanding debts, leaving you with a single payment under one interest rate. 

Some assets aren't exempt from bankruptcy. If eligible, you can exempt your home and car up to a specific value, and you may be able to keep family heirlooms or jewelry. However, you may lose other assets, such as investment and retirement accounts, second vehicles, or vacation homes.

Not all types of debt are eligible for bankruptcy. Alimony and child support can't be discharged, and some unpaid tax debts and loans can't be either. Your attorney can review your debts and explain whether they qualify under bankruptcy law.

Use Greenlight® to get your finances on track

While financial disasters aren’t always avoidable, going into life with personal finance knowledge can prepare you for a healthy financial future. Greenlight, the money and safety app for families, provides fun games to teach kids and teens how to manage debt and budget their money. With Greenlight Infinity, you’ll receive powerful tools to help your kids and teens budget and save. Plus, get up to 5% on savings.* 

*Greenlight Core and Greenlight + Invest families can earn monthly rewards of 1% per annum, Greenlight Max families can earn 2% per annum, and Greenlight Infinity families can earn 5% per annum on an average daily savings balance of up to $5,000 per family. Only Greenlight Max and Infinity families can earn 1% cash back on spending monthly. To qualify, the Primary Account must be in Good Standing and have a verified ACH funding account. See Greenlight Terms of Service for details. Subject to change at any time.