What Bankruptcy Can and Cannot Do

If you are facing severe debt issues, filing for bankruptcy can be a powerful solution. Understanding what bankruptcy can and cannot achieve will help you determine if it's the right option for you. One of its most notable features is that bankruptcy halts most lawsuits, wage garnishments, and other collection actions, while also eliminating various types of debt, including credit card balances, medical bills, personal loans, and more.

However, it doesn't stop all creditors or eliminate all obligations. You will still need to pay student loans (unless you can prove hardship), past due child support and alimony, and recent tax debts. In this article, you'll learn what to expect from bankruptcy and how it works, including what Chapter 7 and Chapter 13 bankruptcy can accomplish, the specific outcomes of Chapter 13 bankruptcy, and what is wholly prohibited in bankruptcy.

What Happens When You File for Bankruptcy: Chapter 7 and 13 Bankruptcy Differences

Bankruptcy helps individuals struggling with debt to eliminate certain obligations and achieve a fresh start. The three primary types of bankruptcy filed, Chapter 7, Chapter 13, and Chapter 11, each offer unique benefits and solutions to debt problems, providing different forms of relief.

Most people file for Chapter 7 or Chapter 13 bankruptcy. Businesses wanting to remain operational typically opt for Chapter 11, although some exceptions exist. Since the two bankruptcy types function differently, the appropriate chapter for you will depend on your income, assets, and goals.

Chapter 7 Bankruptcy: "Liquidation" or Fresh Start Bankruptcy

Chapter 7 is primarily for low-income filers, sole proprietorships that mainly provide services (as they often can remain operational), and closing companies. This chapter typically takes three to four months to complete.

One of the downsides to Chapter 7 is that the trustee assigned to the case sells "nonexempt" property that the filer isn't allowed to keep. Chapter 7 also doesn't offer a payment plan to repay creditors if you've fallen behind on payments, an essential option if you want to keep financed property with a lien on it, such as a house or car. The lien allows the creditor to recover the property when you don't pay as agreed.

Learn more about erasing your debt in Chapter 7 bankruptcy and who can't file bankruptcy in Chapter 7.

Chapter 13 Bankruptcy: Budget-Friendly Debt "Reorganization"

If you have sufficient income to make at least partial payments to creditors, you can benefit from the advantages offered by Chapter 13, notably the repayment plan. You'll repay some debts through the Chapter 13 plan, but you can also use it to catch up on overdue mortgage, car loan, and other secured payments while retaining the property. Discover more about discharging debts in Chapter 13 bankruptcy.

Chapter 11 Bankruptcy: Budget Reorganization for Businesses (and Some Individuals)

Chapter 11 is similar to Chapter 13 but is intended for businesses and individuals with debts exceeding the amount permitted in Chapter 13. Traditionally, it has been complex and costly. However, the more streamlined Chapter 11, Subchapter V option now provides businesses with a more affordable solution.

What Bankruptcy Can Do

Here's what to expect in Chapters 7 and 13.

Stop Creditor Harassment and Collection Activities

Once you file, the court issues an order known as the automatic stay. This stay halts most creditor calls, wage garnishments, and lawsuits, though exceptions exist. For instance, creditors can still collect support payments, and criminal cases will proceed.

Eliminate Credit Card Balances and Most Other Nonpriority Unsecured Debts

Bankruptcy is effective at erasing most nonpriority unsecured debts, excluding student loans and a few others. A debt is considered unsecured if you didn't agree to return the purchased property in the event of nonpayment. For example, you can discharge unsecured credit card debt, medical bills, overdue utility payments, personal loans, and gym contracts with no requirement to return any property acquired.

In contrast, you must return the purchased item if you used a secured credit card. Items such as jewelry, electronics, computers, furniture, and large appliances are often secured by debts. Check the receipt or credit contract to see if you agreed that the purchased item would serve as collateral to guarantee the debt.

Stop a Foreclosure, Repossession, or Eviction, But Sometimes Only Temporarily

The automatic stay will halt these actions as long as they remain pending. Once completed, bankruptcy won't be beneficial.

Evictions. An eviction still in the litigation process will pause after a bankruptcy filing. However, the stay is likely to be temporary. Additionally, if your landlord has already obtained an eviction judgment against you, bankruptcy won't help in most states. Learn more about evictions and the automatic stay.

Foreclosure and repossession. Although the automatic stay will halt a foreclosure or repossession, filing for Chapter 7 won't help you retain the property. If you can't bring the account current, you'll lose the house or car once the stay is lifted. In contrast, Chapter 13 includes a mechanism that allows you to catch up on past payments and keep the assets. Learn more about bankruptcy's automatic stay as it relates to foreclosure and car repossession.

Erase Secured Debt (But You Must Give Up the Purchased Property)

Other debts that people often agree to secure with collateral include mortgages and car loans. Filers can eliminate mortgages, auto loans, and other secured debts in bankruptcy. However, you must return the collateral unless you make arrangements to pay what you owe.

When you voluntarily agree to secure a debt with property, you grant the lender a "lien" on the purchased property. A voluntary lien enables the lender to recover financed property, such as a house or car, if you fail to make payments, even in the event of bankruptcy. You'll learn more about this in "What Bankruptcy Can't Do" below.

Learn how other lien types affect property in Chapter 7 bankruptcy.

Help Rebuild Your Credit

It's nearly impossible to repair your credit when unpaid debts remain on your credit report. Bankruptcy addresses this issue by eliminating many types of debt and allowing you to repay others. You can open new accounts shortly after filing for bankruptcy and responsibly start rebuilding your credit over time. Your credit score will drop following a bankruptcy filing, but the extent of the drop and the time it takes to rebuild will depend on factors such as any late payments made before filing and the chapter you filed. For example, many find that credit recovers quickly after Chapter 13, primarily because it is a lengthy process.

After both Chapters 7 and 13, you'll want to open credit card accounts, but use them wisely. While many report that maintaining a balance below 30% is acceptable, you'll likely find your score improves the most when you pay off the balance in full each month, as this increases your available credit. Additionally, having a mix of accounts is important. For example, obtaining a car loan and mortgage can also be advantageous.

Learn when you'll qualify to purchase a home after bankruptcy.

What Bankruptcy Can't Do

Bankruptcy doesn't resolve all debt problems. Here's what it can't do for you.

Property Loss

You can protect a certain amount of property in Chapters 7 and 13 using bankruptcy exemptions. Bankruptcy exemptions are the laws listing assets that are safe from creditors. However, keeping all your property isn't guaranteed.

Bankruptcy doesn't prevent all property loss. In Chapter 7, the trustee sells property not covered by a bankruptcy exemption. In Chapter 13, you won't qualify unless you can pay creditors an amount equivalent to the value of property not covered by a bankruptcy exemption.

Bankruptcy doesn't prevent a secured creditor from foreclosing or repossessing property you can't afford. A bankruptcy discharge eliminates debts, but it doesn't eliminate liens. A lien allows the lender to take property, sell it at auction, and apply the proceeds to a loan balance. The lien stays on the property until the debt is paid. If you have a secured debt—a debt where the creditor has a lien on your property—bankruptcy can eliminate your obligation to pay the debt. However, it won't take the lien off the property—the creditor can still recover the collateral. For example, if you file for Chapter 7, you can wipe out a home mortgage. But the lender's lien will remain on the home. If the mortgage remains unpaid, the lender can exercise its lien rights to foreclose on the house once the automatic stay is lifted.

Nondischargeable Debts

Not all debts are erased in bankruptcy. Here are the specifics.

Bankruptcy doesn't eliminate child support and alimony obligations. Child support and alimony obligations survive bankruptcy, so you'll continue to owe these debts in full as if you had never filed for bankruptcy. And if you use Chapter 13, you'll have to pay these debts in full through your plan. Learn about nondischargeable obligations.

Bankruptcy doesn't eliminate student loans except in limited circumstances. Student loans can be discharged in bankruptcy only if you show that repaying the loan would cause you "undue hardship," which is a very tough standard to meet. You must prove that you can't afford to pay your loans currently and that there's very little likelihood you can do so in the future. Find out more about the undue hardship standard and student loan debt in bankruptcy.

Bankruptcy doesn't eliminate most tax debts. Eliminating tax debt in bankruptcy isn't easy, but it's sometimes possible for older unpaid tax debts. Learn what's needed to eliminate tax debts in bankruptcy.

Bankruptcy doesn't eliminate other nondischargeable debts. The following debts aren't dischargeable under either chapter:

• debts you forget to list in your bankruptcy papers (unless the creditor learns of your bankruptcy case)
• debts for personal injury or death due to intoxicated driving, and
• fines and penalties imposed as a punishment, such as traffic tickets and criminal restitution.

If you file for Chapter 7, these debts will remain when your case ends. In Chapter 13, you'll pay these debts in full through your repayment plan.

Debt related to fraud might be eliminated. Bankruptcy won't discharge a fraud-related debt if a creditor files an adversary proceeding lawsuit and convinces the judge that the obligation should survive your bankruptcy. Such debts might result from lying on a credit application or passing off borrowed property as your own to use as collateral for a loan. Find out more about bankruptcy fraud.

Social Stigma and Inconvenience

Filing for bankruptcy once caused many to feel shame, but this changed significantly after the mass bankruptcy filings during the Great Recession. However, no one wants to file for bankruptcy, and most people explore all other options before doing so. Unfortunately, there's no way to avoid drops in credit scores and temporary difficulties in leasing a home, opening bank accounts, and other financial activities.

What Only Chapter 13 Bankruptcy Can Do

Chapter 13 offers more benefits than Chapter 7. Here are some things only Chapter 13 can do.

Stop a mortgage foreclosure. Filing for Chapter 13 bankruptcy will halt a foreclosure and compel the lender to accept a plan that allows you to gradually catch up on missed payments. To ensure this plan is successful, you must show sufficient income to cover overdue amounts and stay current on future payments. Learn more about your home and mortgage in Chapter 13 bankruptcy.

Allow you to keep property not protected by a bankruptcy exemption. No one gives up everything they own in bankruptcy. You can save (exempt) items you need to work and live by using bankruptcy exemptions. A Chapter 7 debtor relinquishes nonexempt property—the trustee liquidates unprotected property for creditors—but not a Chapter 13 filer. While it might seem like you get to keep more assets, that's not true. Chapter 13 filers pay the value of nonexempt property to creditors through the repayment plan.

Protect a cosigner or codebtor. Filing for Chapter 7 doesn't protect a cosigner from a creditor. The creditor remains free to collect from them even after you file for bankruptcy, as Chapter 7 only eliminates your obligation. However, a Chapter 13 plan that pays off the debt typically provides more protection for the cosigner.

"Cramdown" secured debt when property is worth less than the amount owed. Chapter 13 includes a procedure that allows you to reduce an obligation to the replacement value of the property securing it. For example, if you owe $10,000 on a car loan and the car is valued at only $6,000, you can propose a plan that pays the creditor $6,000 and discharges the remaining balance. However, exceptions exist. For instance, you can't cram down a car debt if you purchased the vehicle within the 30 months before bankruptcy. Additionally, filers cannot use the cramdown provision to reduce a residential mortgage. Learn more about lowering loans through a "cramdown" in Chapter 13.

Use "lien stripping" to eliminate a junior residential home loan. This benefit isn't available unless your home is worth significantly less than the total amount you owe. Learn more about lien stripping in Chapter 13 bankruptcy.

Essential Factors for Deciding Between Chapters 7 and 13

Not everyone qualifies for bankruptcy, and not everyone will benefit from filing. You'll want to consider the following when choosing the right approach.

Debt Type and Amount

Assess the amount of debt you can discharge in your Chapter 7 case. While you don't need to owe a specific amount to file, since you can only file for Chapter 7 every eight years, it's essential to ensure you can eliminate enough debt to make it worthwhile. If you couldn't pay off the debt in less than five years, filing for Chapter 7 is likely a solid choice.

Filing for Chapter 13 is often a viable option if you have nondischargeable debt that you'd like to repay over time without creditor harassment, or if you need to catch up on a house or car payment to avoid foreclosure or repossession.

Property

Review your state's bankruptcy exemptions to see what you can protect. If you would lose property in Chapter 7, assess whether the amount of debt you would eliminate justifies the filing. If it doesn't, you might be better off selling property and paying off debts outside of bankruptcy. Alternatively, consider whether paying to retain property you would lose in Chapter 7 through a Chapter 13 plan is worthwhile.

Income and Expenses

Your income and expenses play a significant role in determining your eligibility for Chapter 7 or Chapter 13. In Chapter 7, your income must be low enough to pass the Chapter 7 means test. In Chapter 13, you must earn sufficient income to cover all required plan payments and monthly household expenses.

Financial Goals

Negotiating life is easier when you're not living paycheck to paycheck and have a healthy credit score. Most bankruptcy filers significantly enhance their long-term financial outlook after filing. Not only can they eliminate numerous debts, but most can also retain their retirement accounts, positioning themselves in a much better financial state moving forward.

Need More Bankruptcy Help?

Did you know that Nolo has been making the law accessible for over fifty years? It's true, and we wholeheartedly encourage research and learning. You can find many more helpful bankruptcy articles on Nolo's bankruptcy homepage. For instance, Nolo articles explain what bankruptcy can do, what you should avoid before filing, and more. The information needed to complete the official downloadable bankruptcy forms is available on the Department of Justice U.S. Trustee Program website.

However, online articles and resources can't address all bankruptcy issues and aren't tailored to the specifics of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.