What Is Bankruptcy? A Guide to How It Works and What It Means for You

If you're struggling financially, bankruptcy can offer an opportunity to start fresh. This legal process can provide relief from debt you can't repay, either by wiping it away or setting up a plan for repayment. Between December 2023 and 2024, 517,308 bankruptcy cases were filed, according to data compiled by U.S. bankruptcy courts.

While this might sound like a quick path toward a solution, the process of filing for bankruptcy is involved, and it won't necessarily result in the discharge of all your debts. Further, bankruptcy will impact your credit for years to come, among other financial consequences.

Here's what you need to know about bankruptcy, including the various types and alternatives to consider.

What is bankruptcy?

Bankruptcy is a legal process that individuals or businesses can turn to when they're unable to pay their debts. By filing for bankruptcy, it's possible to get relief from some or all debts owed (with some exceptions), or to enter a repayment plan under the protection of a bankruptcy court.

After you file for bankruptcy, creditors can no longer continue collection efforts.

“It really gives people a peace of mind that they don't have to deal with the phone calls, they don't have to deal with the garnishments, they don't have to deal with everything else,” says Chad Van Horn, a board-certified attorney in consumer and business bankruptcy law and managing partner at Florida-based Van Horn Law Group.

Alongside the relief it can provide, however, bankruptcy can also lead to the loss of assets and property and carries with it long-term financial consequences.

Types of bankruptcy

Most commonly, individuals file for one of the following two types of bankruptcy:

• Chapter 7 bankruptcy: In Chapter 7 bankruptcy, the court sells your assets and then uses the proceeds to repay your creditors. It's possible to keep some assets, known as exempt property. To qualify for this type of bankruptcy, you must earn under a certain income threshold.
• Chapter 13 bankruptcy: With Chapter 13 bankruptcy, individuals with regular income enter a debt repayment plan that spans 3 to 5 years, with payments based on what they can afford. This makes it possible to retain your assets, including avoiding foreclosure on your home. After this period ends, you can have some or all of your remaining debt discharged.

In general, Chapter 7 bankruptcy is viewed as “easier, cleaner, faster, and cheaper in terms of attorney's fees and costs,” as it can allow you to get your debt discharged in just a few months after filing, says John C. Colwell, a certified bankruptcy law specialist in California and an attorney at the Debt Relief Legal Clinic. With Chapter 13, “you still get a discharge order at the end but don't get it for three, four, or five years,” adds Colwell.

There are many other types of bankruptcy beyond Chapters 7 and 13. For instance, Chapter 9 bankruptcy is designed for municipalities, such as cities and towns, whereas Chapter 11 bankruptcy is mainly used by businesses to try to change the terms of their debt. Meanwhile, Chapter 12 bankruptcy is specifically for family farmers and fishermen who are still bringing in income but struggling financially.

How the bankruptcy process works

Before filing for bankruptcy, whether Chapter 7 or Chapter 13, it's necessary to take a credit counseling course with an approved nonprofit agency. You might also use this time to evaluate your outstanding debts and assess which type of bankruptcy might be best suited to your situation — a bankruptcy attorney can assist in both of these areas.

From there, the first step in the bankruptcy process is to file a petition with the bankruptcy court and pay a filing fee. You'll also need to provide information on your financial situation, including your assets and debts.

After you've filed, an automatic stay will typically take effect. This prevents most creditors from continuing their collection efforts, at least for a certain period of time.

Then, within 21 to 50 days of filing for bankruptcy, what's known as a meeting of creditors will be held. Prior to this meeting, your trustee, an administrator who will be appointed by the court to oversee your bankruptcy case, will request copies of your federal tax return from the year prior to your bankruptcy filing, as well as pay stubs, which you're required to provide. At this meeting, the trustee will ask about your filing and your financial situation.

From there, depending on the outcome of the meeting, you might either have your debts wiped out (in the case of a Chapter 7 bankruptcy) or enter a repayment plan (for Chapter 13). It's also possible for your case to be dismissed entirely or for creditors or your trustee to object.

According to Colwell, the “success rate on Chapter 7 bankruptcies is very high,” whereas Chapter 13 bankruptcies “are generally less successful” given how much can change over the course of the years-long repayment plan.

How bankruptcy affects your finances

Before filing for bankruptcy, it's critical to fully understand how it can affect your finances, both in the short term and in the future.

Depending on the type of bankruptcy you've opted for, you might either see your debts generally wiped away, or you could have them restructured into a repayment plan. For the former, which is Chapter 7 bankruptcy, your nonexempt assets will be sold so the funds can be used to pay off your debts. This might include the loss of property, particularly if you include secured debt, such as a mortgage, in your filing. There's also no guarantee that all of your debts will be erased, as certain types of debt — including child and spousal support, student loans (except in limited circumstances), and most tax debts — are not dischargeable through bankruptcy.

Meanwhile, with Chapter 13 bankruptcy, which involves debt restructuring, you generally get to keep your assets and property, but you'll remain responsible for repaying the debts you've racked up, usually over a period of three to five years.

Post-bankruptcy, both Chapter 7 and 13 can have significant effects on your credit score and your ability to borrow money. Both types can have a dramatic negative effect on your credit, with Chapter 7 bankruptcy remaining on a credit report for 10 years from the date of discharge, and Chapter 13 being reported for seven years following the date of filing. These marks on your report can drag down your score by as much as 200 points, making it far less likely that you can get approved for lines of credit and loans after bankruptcy, and at competitive terms.

Still, if you're stuck in a cycle of debt, declaring bankruptcy can help you improve your situation, eventually improving your credit in the long run. Often, according to Van Horn, “the only way to legally fix the credit is by taking care of the debt either by settling or declaring bankruptcy.”

Alternatives to bankruptcy

Typically, bankruptcy should be viewed as a last resort due to its serious financial implications. You can utilize other avenues to help you get a handle on your debt that generally have lesser consequences, such as:

• Debt consolidation: If your credit is still intact, debt consolidation might be worth exploring. With this option, you take out a new debt consolidation loan, which you then use to repay all of your existing debt. Afterward, you only have to worry about repaying that one loan, which could also have a lower interest rate than your previous debts. Just keep in mind that your approval and rate depend on your credit, which means it might not be an option for some.
• Debt settlement: Debt settlement can allow you to settle up with your creditors for less than the full amount you owe. You can negotiate for debt settlement on your own, or you can work with a debt settlement company, though this will entail fees, and not all creditors will work with these companies. Be sure to research carefully before going through with debt settlement.
• Payment plans with creditors: If you're in debt and behind on payments, your creditor might be willing to work with you on setting up a payment plan. Before making a proposal or agreeing to any arrangement, carefully consider how much you can realistically afford to pay each month. Make sure to get any agreement you come to with the creditor in writing.
• Credit counseling and financial management programs: If you're looking for guidance alongside a path out of debt, credit counseling and financial management programs are worth exploring. Credit counselors can help you set up a plan to pay off your debt. This usually entails making payments to the credit counseling organization, which in turn pays your creditors. Though this arrangement likely won't result in paying a lesser amount, it's possible to extend your repayment timeline or to secure a lower interest rate, alongside receiving financial guidance to move forward.