Bankruptcy Explained: The Different Types and How It Works

If you’re thinking about (or in the middle of) bankruptcy, we know how scary it can be. But you need to know what you’re getting yourself into before you throw a Hail Mary and declare bankruptcy.

While bankruptcy can get rid of some of your debt, it isn’t the clean slate people think it is. Bankruptcy can have lasting effects on your finances—including your ability to get a mortgage. The good news is, there are ways to deal with your debt before bankruptcy becomes your only option.

Let’s break down everything you need to know about bankruptcy—so you can make the best decision for your situation.

What Is Bankruptcy?
How Bankruptcy Works
Does Bankruptcy Clear All Debt?
The Types of Bankruptcy
What Happens When You File for Bankruptcy?
The Downsides of Filing for Bankruptcy
Should You Declare Bankruptcy?
5 Bankruptcy Alternatives
Bankruptcy FAQ

Bankruptcy is a legal process where an individual or business declares they can’t pay their debts, and the court decides which debts will be erased and which debts must be paid back.

While bankruptcy can offer some relief from debt collectors and even stop a foreclosure from happening, it’s not a decision to make lightly. Bankruptcy is rough—financially and emotionally. It should be your very last option after you’ve tried everything else to get out of debt.

But even if bankruptcy is the route you take, you can get through it. That said, let’s talk about how bankruptcy works so you know what to expect.

When you file for bankruptcy, you’re assigned a court trustee who looks through your assets (what you own) and liabilities (what you owe). If the court finds that you have no means to pay back what you owe, the judge will discharge (or cancel) some or all of your debt.

In most bankruptcy cases, the court will require you to sell your assets to pay off your creditors (aka the people you owe money to)—this process is called liquidation.

But hear us when we say this: Bankruptcy is not a way to have all your debt cleared and keep all your stuff. With secured debt (that’s debt that has an asset tied to it), you have to either sell the item or reaffirm the debt. In other words, if you want to keep your car or house, you also have to keep the payments. No way around it.

All bankruptcy cases in the U.S. go through the federal court system. And the process can take anywhere from four months to five years. But the exact details depend on the specific bankruptcy laws in your state and the type of bankruptcy you file.

No, bankruptcy doesn’t clear all kinds of debt. Unsecured debt—like medical debt and credit card debt—usually gets erased, but there are some things bankruptcy won’t help you get rid of.

Bankruptcy doesn’t erase:

• Student loans
• Government debts like tax debt, fines or penalties
• Child support and alimony
• Secured debts like your home mortgage or a car loan (you’ll have to either sell them to pay your lenders or negotiate payments to keep them)
• Expensive items purchased right before filing bankruptcy, like boats or jewelry (bankruptcy isn’t a hack to get free stuff!)

There are six different types of bankruptcy, but Chapter 7 and Chapter 13 are the most common for individuals.

Chapter 7: Also known as liquidation bankruptcy, Chapter 7 bankruptcy requires individuals to sell their non-exempt assets to pay creditors.
Chapter 13: Chapter 13 bankruptcy allows individuals with higher income to pay off their debt through a court-approved repayment plan.
Chapter 11: Chapter 11 bankruptcy allows businesses to still run while paying off their debt.
Chapter 12: Chapter 12 bankruptcy allows farms and fisheries to get on a payment plan for their debts to avoid foreclosure on their property.
Chapter 15: Chapter 15 bankruptcy is for international bankruptcy cases.
Chapter 9: Chapter 9 bankruptcy is a repayment plan for towns, cities, schools and other municipalities.

Each person’s bankruptcy process looks different. But because of a court order called automatic stay, there are several things that immediately happen when you file for bankruptcy:

• Creditors must stop trying to collect money from you.
• Any foreclosures on your home or property are postponed.
• Lenders can’t repossess your car.
• Your wages can’t be garnished. (Wage garnishment is when the court orders part of your paycheck to be sent directly to your creditor—without you ever seeing the money.)

We won’t sugarcoat it: Bankruptcy is a devastating, life-altering decision that drags you through the legal mud for all to see. Beyond the emotional impact, here are some ways bankruptcy can wreck you financially:

Your bankruptcy becomes public record.

When you file for bankruptcy, 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. And if you’ve got a history of not managing your money well, it could affect your chances of getting a job or working with certain clients.

Filing bankruptcy is expensive.

The filing fees amount to $335 for a Chapter 7 bankruptcy and $310 for a Chapter 13.^1,2 Not to mention, you’ll want to hire a bankruptcy attorney—which can cost you thousands of dollars. So, even if you have your debts cleared after a bankruptcy, you’ll still have to pay a decent amount just to go through the process.

Bankruptcy affects your credit score.

Listen, we aren’t pro-credit score around here, but it’s important to know that a bankruptcy will affect your FICO score. Hard. And that hit lingers. In fact, Chapter 13 bankruptcies stay on your credit report for about seven years, and Chapter 7 bankruptcies stay on there for 10 years.

You could have trouble getting a mortgage after bankruptcy.

A bankruptcy is a huge red flag for mortgage lenders. While it’s not impossible to buy a home after going through bankruptcy, it could take one to four years before anyone will even think about letting you take out a mortage.³ How soon you can qualify again depends on the type of bankruptcy you filed and the type of mortgage.

Bankruptcy doesn’t clear all debts.

Like we said before, declaring bankruptcy doesn’t make all your problems go away—and it doesn’t even make all your debt go away. Student loans, alimony, child support, reaffirmed debt (debt you negotiate with a creditor to repay), unpaid taxes, government debts and court fines are not erased in a bankruptcy.

Look, we’re not going to tell anyone they should declare bankruptcy, especially when we know how much damage it can do. Whether or not you should file for bankruptcy really depends on your specific situation and how much unsecured debt you have.

For some people, bankruptcy really is the last resort for getting out from under a mountain of debt. But many people considering bankruptcy can actually pay off their debt faster than they think!

Again, bankruptcy should be your very last option. Do everything in your power to avoid it. That said, let’s talk about some alternatives to filing for bankruptcy.

1. Negotiate with your creditors.

If you’ve fallen behind on your payments, start by calling your creditors to negotiate. After all, creditors would rather get some money from you than risk getting no money in bankruptcy. This is especially true if you’ve got medical debt you can’t pay.

If you’ve fallen behind on your mortgage, your loan servicer can give you time to catch up on your payments through forbearance. They may even allow you to restructure your loan or lower your interest rate. While loan modification doesn’t solve your problem, it can delay it enough to help you get back on your feet.

2. Get on a budget.

Budgeting may seem intimidating, but it’s simply about making a plan for your money. And the truth is, you can’t get out of debt without a budget. You need to know where your money is currently going so you can put more of it toward your debt. Otherwise, you’ll have to stick to a court-mandated budget during bankruptcy (and trust us, that’s way less fun).

So, if you’re not already budgeting, the best time to start is right now. The EveryDollar budgeting app makes it easy to catch up on your bills and pay off your debt—one month at a time. Plus, it’s free!

3. Lower your expenses.

If you’re in debt up to your eyeballs, you need to free up as much money as you can to make progress. So when you make your budget, cover your Four Walls first—that’s food, utilities, shelter and transportation. These are the essentials. Keep everyone fed, the lights on, a roof over your heads, and gas in the car to get to work.

Then, it’s time to cut extra spending like you never have before. Subscriptions or memberships you don’t use, entertainment, eating out—these are things you can live without for a time while you save money and clean up your debt.

Yes, it’s work. But if it keeps you from bankruptcy, it’s 100% worth it.

4. 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. Have a garage sale or list everything online. Then, put all of that money straight toward your debt.

Instead of a bankruptcy trustee, you can be the one in charge of what goes and how the money from the sales gets used.

5. Increase your income.

Another great way to avoid bankruptcy is to make more money to put toward your debt. You can do this by taking on a side hustle or working extra hours. There are 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 against your debt. It’s going to take some hard work and sacrifice to fight your way out. But it’s still better than the financial and emotional beating you go through during bankruptcy.

Considering Bankruptcy? Get Help From a Financial Coach

You don’t have to walk through this alone. Read that again: You don’t have to walk through 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 situation. And yes, talking about money can be scary, but if you declare bankruptcy, your financial privacy will fly 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 later. So connect with a coach today.