What is Chapter 7 bankruptcy?

Worried couple looks at documents.Image: Worried couple looks at documents.

In a Nutshell

Have you tried everything to catch up on your debt but still can’t seem to manage? If you’ve exhausted all your options, Chapter 7 bankruptcy, while it comes with serious consequences, might be the next option to consider.
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If you qualify, Chapter 7 bankruptcy may allow you to discharge a variety of debts, but typically excludes obligations like child support, student loans or tax debt.

“The main benefit of filing for Chapter 7 bankruptcy is that it can give the honest debtor a fresh start,” says bankruptcy attorney Richard Symmes, principal attorney at Symmes Law Group.

But it isn’t a simple fix-all. The repercussions of filing Chapter 7 bankruptcy can include losing some of your physical assets and having your credit take a major hit.

Chapter 7 bankruptcy may be able to offer the financial reset you need, but you should know about the drawbacks before you consider filing.

When to consider filing Chapter 7

If you’ve tried negotiating with your creditors, working with a credit counselor or consolidating your debt, but are still struggling to manage your debt, Chapter 7 bankruptcy might be your last resort.

Chapter 7 bankruptcy can help by acting like a “pause” button for some of your debts. Once you file your petition, some of your creditors could be temporarily stopped from most collection actions against you or your property.

But filing Chapter 7 can ultimately mean losing some assets. The law varies from state to state, and each state can classify property as exempt (can’t be taken) or nonexempt (can be taken). So depending on where you live, your home, stocks, other investments as well as other nonexempt assets you have could be at stake.

If you’re concerned about what you may have to forfeit, talk to a lawyer. Some assets, including 401(k)s and pensions, may be exempt.


What does it mean to have equity?

If you have equity in an asset, like a house or a car, that means it’s worth more than what you owe for it. An easy way to think about it is if the asset is sold, would you end up with cash left over once you pay the remainder of what you owe? If the answer is yes, that generally means you have equity in that asset.

What does filing involve?

The process of filing Chapter 7 bankruptcy generally takes 80 to 100 days from filing to when your debts are discharged. You’re not required to hire an attorney, but it is recommended that you go through this process with professional guidance from an attorney.

Here are some of the things you should be prepared to do during a Chapter 7 bankruptcy.

  1. Complete bankruptcy counseling through an approved agency within 180 days before filing.
  2. Pass a “means test.” The test is whether your income exceeds a certain amount. This requires you to show that you are eligible to file for Chapter 7 bankruptcy based on your state’s income standards.
  3. File a petition with your local bankruptcy court. This will include paying court fees of up to several hundred dollars. You’ll also have to submit additional information, including information about your income and expenses. You’ll also need to provide your most recent tax returns.
  4. Attend a creditor meeting (known as the Meeting of Creditors) with your bankruptcy trustee and any of your creditors who choose to appear. Your bankruptcy trustee will be assigned to you. You’ll be required to answer questions about your debt, property and financial situation under oath.
  5. Complete a financial management course through an approved agency. You’ll need to complete the course and submit a form certifying you completed the course (Form 423) within 60 days of the first date set for the Meeting of Creditors.
  6. Receive your discharge. This permanently stops creditors from collecting on any of the specific debts that were discharged in the bankruptcy. Remember, not all your debts are dischargeable in bankruptcy.

Drawbacks of Chapter 7 bankruptcy

Before you decide to file, there are several drawbacks of Chapter 7 bankruptcy to be aware of.

  • You may have liens placed against your property. A lien gives your lender a stake in your property. If the property is sold, the lender can be paid from the earnings.
  • You may lose property. Your property may be sold in order to pay creditors.
  • Your credit may be damaged. Derogatory public records, including bankruptcies and foreclosures, included in your credit reports have the potential to reflect poorly on your credit and can hurt your ability to qualify for new loans.
Chapter 7 vs. Chapter 13 bankruptcy: What's the difference?

How can Chapter 7 bankruptcy affect my credit?

One of the major repercussions of filing for bankruptcy is the likely hit to your credit. According to VantageScore Solutions, a company that provides scoring models that calculate some of your credit scores, filing for bankruptcy can have a more severe negative impact on your credit than many other financial events.

How many points can you lose? It will vary depending on your current scores and other factors relating to your financial situation. While the impact to your credit can decrease over time, your scores will probably take the biggest hit upfront.

Chapter 7 bankruptcy stays on your credit reports for up to 10 years. Bankruptcy won’t necessarily prevent you from qualifying for new credit or even from being approved for a mortgage, but it can mean facing higher interest rates and fees.

Remember that no matter what the impact, your credit can be improved with time and effort. By practicing healthy financial habits — paying bills on time, keeping credit card balances low, and trying not to apply for multiple new loans or credit in a short period — you can eventually build your credit.

Bottom line

Filing Chapter 7 bankruptcy is a serious legal action. It can lead to losing valuable property, cash and other assets and can cause a major hit to your credit.

But if you’re facing a mountain of debt, and despite your best efforts and seeking help you can’t seem to find a way out, bankruptcy may be an option to consider.

About the author: Sarah C. Brady is a San Francisco–based financial consultant, workshop facilitator and writer. In addition to writing for Credit Karma, Sarah writes for Experian, LendingTree, Magnify Money, MSN News and more. In her … Read more.