Understanding the Bankruptcy Rules

Updated on November 22, 2006.

BANKRUPTCY IS A BIG step — one that will follow you around for seven to 10 years, depending on the route you take. And the requirements have become much stricter thatn they were a few years ago, thanks to changes in bankruptcy law.

Here are answers to the 10 most frequently asked questions about bankruptcy.

Chapter 13, on the other hand, is a repayment plan: You set up a three- or five-year schedule with your creditors. Chapter 13 bankruptcy remains on your credit report for seven years. With this type of bankruptcy, you get to keep all of your property, including your home.

2. Is Chapter 7 Bankruptcy Right for Me?
You might be a candidate for Chapter 7 if you have no assets to lose, like a house or a car, and if after you pay for your basic monthly expenses you have no money left to pay off debts. Chapter 7 essentially wipes the slate clean, but you'd most likely lose any valuable possessions.

Just how much a filer will have to hand over depends on where he or she lives, and for how long, explains Howard Ehrenberg, managing partner of SulmeyerKupetz, a Los Angeles-based law firm specializing in bankruptcy. If you've lived in your state for fewer than 730 days, you must abide by the exemption rules of the state where you lived before moving. This requirement was introduced to stop people from moving to a state that has better exemptions and declaring bankruptcy the following day, Ehrenberg says.

Exemptions vary greatly from one state to another. In Florida and Texas, for example, filers can keep their home no matter how much it's worth, but most other states exempt only a limited amount of home equity or other property.

The exemptions for other assets, such as bank and retirement savings accounts and property like furniture and clothes, also vary widely. (Note that 401(k) accounts, Social Security income and individual retirement accounts are federally exempt in bankruptcy.) According to Ehrenberg, no one is in danger of losing personal items that might be hard to sell, like old furniture.

Bankruptcyaction.com, a bankruptcy-information web site, has a detailed list of exemptions by state.

3. When Does Chapter 13 Make Sense?
Chapter 13 is typically recommended for debtors who've fallen behind on their payments because of a temporary problem such as a job loss, but who can get back on track if given time to catch up, says Jay Fleischman, a bankruptcy attorney with Fleischman Law in New York. After filing Chapter 13, a repayment schedule is established that eliminates all interest payments as part of the deal.

4. Can I Choose the Type of Bankruptcy I File?
Today's bankruptcy rules impose requirements for filing the potentially more advantageous Chapter 7. According to these rules, you qualify only if your average income for the past six months before filing is lower than your state's median. Research has found that about 85% of bankruptcy filers are, indeed, below that median, according to Steve Elias, a bankruptcy attorney and author of "The New Bankruptcy Law," published by NOLO.

If your income is above the state median, you will have to take the so-called means test. You won't qualify for filing Chapter 7 if you have enough disposable income to pay off $10,000 or 25% of your unsecured debt over five years, according to Ehrenberg. Disposable income is determined by subtracting from your income basic expenses such as housing, car payments, food and so on. Note that these aren't your actual expenses, but rather the so-called "allowable living expenses" published by the IRS. (To see the national standards for allowable living expenses in your state, click here.)

If you fail the means test, you may still plead with the judge to allow you a Chapter 7 filing if you have extraordinary circumstances. Right now, for example, special rules still apply for victims of hurricanes Rita and Katrina. (For more on that, see our sidebar.)

5. Do I Have to Go Through Credit Counseling Before I File?
Yes. As of October 2006, you must be able to certify that counseling did occur within six months before filing your bankruptcy papers, but you do not need to submit the certificate of completion until 15 days after filing, says Elias. (For a list of the approved agencies, click here.) And if the credit counselor recommends that you go through an independent repayment plan rather than filing bankruptcy, says Ehrenberg, that will be a black mark on your papers if you still decide to go ahead and file. Your Chapter 7 filing may be dismissed or converted to a Chapter 13, with your agreement.

In addition, both Chapter 7 and Chapter 13 filers will have to go to a personal financial-management course in order to exit bankruptcy. This is something like traffic school and can be done in person, over the phone or online, according to Elias. (For a list of the agencies approved to provide such courses, click here.)

6. Are There Any Restrictions on the Kind of Debts That Can Be Discharged?
Yes. Child-support, alimony payments and past tax bills are never dischargeable. Student loans are forgiven only in rare situations. "It is possible to do it only if you can prove health problems that prevent you from working," says Robert Meyer, a bankruptcy attorney in Miami. "It's a threshold most people cannot pass." He says that in his 22 years of practicing law, he has had only one discharge of student loans — for a client diagnosed with a heart condition and a life expectancy of three to five years.

Creditors also have the right to object to the discharge of certain unsecured debts, such as large purchases for luxuries of $500 or more or cash advances made within 90 days of filing. And any cash advance of $750 or more taken within 70 days before filing is also considered non-dischargeable, says Elias.

7. Can I Choose Not to Discharge Certain Debts in Chapter 7, Like a Car Loan or Mortgage?
That depends on how much equity you already have in those properties. Theoretically, you can keep a debt obligation after bankruptcy by signing a reaffirmation agreement with your creditor. With such an agreement, you're basically stating that you'll continue to make payments on the debt, even after all your other debts are written off. So, for example, if a Chapter 7 filer wanted to keep a car, he would sign a reaffirmation agreement with his auto lender and continue to make the car payments during and after his bankruptcy.

Your second option is to "redeem" the asset, which is basically buying it from the lien holder for its replacement value. The replacement value for a car, for example, will be listed in the Kelly Blue Book. In that case, of course, you would have to come up with a lot of cash.

Your third option is to surrender the car to the trustee, who will sell it to pay off the lien holder, give you the amount of the exemption and distribute the rest among your unsecured creditors.

You have to submit a special Statement of Intention along with the bankruptcy papers announcing which of the three options you choose. If you don't, Ehrenberg explains, the creditor can repossess the asset at any time.

8. What Happens to My Credit After Bankruptcy?
The most obvious thing that happens when you file for bankruptcy is that you get a notation on your credit report. Your credit score, which is the number creditors use to evaluate your credit-worthiness, will likely take a hit. Just how badly it will suffer depends in part on how high it was before you filed (scores can range from 300 to 850; the higher the number, the better) and how many accounts you're including in the bankruptcy, explains Craig Watts, consumer-affairs manager at Fair Isaac Corporation, a company that calculates scores. (You can order your credit score from Fair Isaac. Once you purchase it, you can simulate what will happen to it if you file bankruptcy with Fair Isaac's credit-score simulator.)

Gerri Detweiler, a leading expert on credit and author of "The Ultimate Credit Handbook," says she has seen scores fall to the 400-point range, too low for a person to obtain new credit. Granted, if you were already suffering with late payments and delinquent accounts, chances are your score was low to begin with and bankruptcy won't sink it that much further. And the good news is, it won't stay that way forever. "While bankruptcy is very negative, it doesn't mean you can't build good credit [ever] again," she says.

9. How Do I Rebuild My Credit?
After filing bankruptcy, many folks are afraid to take on new credit. After all, it was credit that got them in trouble in the first place.

But not doing so can hurt you later on, particularly if you plan to take out a car loan or mortgage eventually, says Detweiler. With the following credit-rebuilding plan, you could see your score shoot above 600 in six months.

First, you need to make sure all of your accounts are listed in your credit reports as charged off or included in bankruptcy. For Chapter 7, they should also show balances of zero. These accounts will remain on your reports for seven years, but you may call your creditors and ask them to stop reporting them to the bureaus. They don't have to do it, but it doesn't hurt to try. If you were able to remove even a couple of charge-off accounts from your record, it would boost your credit score, says Detweiler.

Next task: Get new credit cards. Credit-card companies won't be clamoring to extend you new credit once they see the bankruptcy note on your record, but you could get a secured credit card, which is basically a regular credit card backed by a security deposit you leave with the card issuer for as long as you have the account. Your credit limit will be equal to the amount of your deposit, which will be returned to you in full when you close the account or graduate to a regular, unsecured card, explains Detweiler. One thing to keep in mind is that secured credit cards usually carry an annual fee and higher interest rates.

Another fast (and perfectly legal) credit-rebuilding strategy is "piggy-backing" on someone else's credit by asking a friend or relative to add you as an authorized user on one or more credit-card accounts. You won't be responsible for the bills, and you won't have access to the credit cards unless the original owner wants a copy to be sent to you, says Detweiler. The primary cardholder's credit record won't be affected in any way by your bankruptcy. You, on the other hand, "get the benefit of their credit history right away," she says. The potential drawback is that your own credit could be damaged if your credit benefactor gets into financial trouble.

10. How Soon Can I Consider Larger Loans, Like a Mortgage or Car Loan?
You don't have to wait for the bankruptcy notation on your record to expire before you apply for a mortgage or car loan. These days, you can get a mortgage within a year after bankruptcy, says mortgage expert Brian Sacks, author of "Yes, You Can Get a Mortgage," a book on mortgage lending for bankruptcy filers. Most mortgage lenders want to see about a year's worth of on-time payments on various accounts, which may include things like utility bills. Needless to say, you won't get the lowest rates possible. The same applies to car loans.