What Does Bankruptcy Do?

Debt Relief: What Bankruptcy Can Do

Bankruptcy is by far the most effective tool at the disposal of people in financial distress. Bankruptcy can eliminate many types of debt, help stop a foreclosure, prevent car and property repossession, and help get people back on their feet financially. No other debt relief option offers the kind of protection and debt relief that US bankruptcy laws do.

That being said, bankruptcy cannot eliminate all types of debt, and it does not allow people to keep property without paying for it. You can't go out and buy an expensive car just to file bankruptcy and expect to keep it. In this section of the bankruptcy guide, we will discuss in detail what bankruptcy can do, and the options available to help debtors get control of their financial situation.

Once Bankruptcy Is Filed: The Automatic Stay

When a bankruptcy petition is filed with the court, the paperwork includes a "creditor matrix." This is essentially a contact list of all the creditors involved in the bankruptcy filing. The purpose of this form is to allow the courts access to contact information so that all creditors can quickly be notified of the case.

All the creditors are sent official notice from the court, notifying them that their interests in debt have become part of the bankruptcy estate, and they can take no action to attempt to collect this debt. This includes contacting the debtor, repossessing property, garnishing or "attaching" wages, filing a lawsuit or any other attempt to collect on outstanding debt. In legal terms, all their collection attempts are "stayed," which is why this protection is called the automatic stay.

What This Means for the Debtor

The automatic stay protects the debtor from all collection attempts, and ensures that no creditor can attempt to collect on any debt until the bankruptcy court has decided which creditors will receive money, if any. For the bankruptcy petitioner, this means that they no longer have to worry about their car being repossessed due to an unpaid car note debt, or a foreclosure due to a default on mortgage payments.

It also provides relief from creditor harassment, so the calls, letters and sometimes even visits to their home are all stopped. If a creditor attempts to contact the debtor in any way, or tries to collect or repossess property or garnish wages, they will be in violation of a court order and can be held in contempt.

What Can Creditors Do About the Stay?

In most cases, the creditors are powerless to do anything about the automatic stay. However, in certain situations a creditor may file for a "relief from automatic stay," which means they can claim that the stay is wrongful or unlawful. The only time this can work for a creditor is if the debt was accrued under fraudulent circumstances, or the petitioner is found to be abusing the bankruptcy laws. This can happen in cases where a debtor deliberately takes on certain debt knowing in advance that they will be filing bankruptcy. This includes the situation noted above, where a debtor buys an expensive car without any intention of paying for it, knowing they will soon be filing for bankruptcy. The important concept to be aware of is that bankruptcy laws are written in such a way as to provide honest debtors relief from overwhelming debt. Anyone attempting to abuse the help offered by the court will soon find out that it will not work, and the case will likely just be dismissed.

Dischargeable: Different Types of Debt in Bankruptcy

The most common types of debt are typically discharged in a bankruptcy. This includes most unsecured debts such as credit card debt, personal loans, bank loans (not including loans against property), payday or cash advance loans, debt from unpaid medical bills and other common unsecured debts. Once the bankruptcy is completed, these debts are discharged, which means the creditor's claim against the bankruptcy filer is removed, and the debtor is no longer liable to pay it.

A Snapshot of Dischargeable and Non-Dischargeable Unsecured Debt

Here is a quick overview of the different unsecured debts in bankruptcy and how they are handled:

What About Secured Debt?

Secured debts are those that are "guaranteed" by a certain asset, usually by a lien on some property. The most common secured debt for most people would include a home mortgage, investment property loans, car notes and certain home equity loans.

In general, secured loans are not dischargeable in a bankruptcy case. There are cases where some of the debt may be discharged, and this usually occurs when the property securing the loan has a market value below the total amount of debt owed against it. When this is the case, a concept called a "cram down" or "lien stripping" may be used.

Lien Stripping and Cram Downs

In the eyes of the court, a debt can only be secured by an asset of equal or greater value. If the property securing the loan is worth less than the loan itself, some portion of that debt becomes unsecured.

Take, for example, a typical car loan. When you buy a new car, you typically pay retail value, but the moment you drive it off the lot, its value drops because it has become a used car. A few months or even years down the road, the car value continues to depreciate, often faster than the rate at which you pay off the loan. This means that a one year old car worth $15,000 often has a $20,000 loan against it.

In a bankruptcy case, that $5,000 difference may be "stripped" of the lien, making it unsecured and dischargeable. This means the bankruptcy petitioner can remove some of the debt against the car, which can significantly lower the monthly payment. Essentially, the loan is "crammed down" to the market value of the car.

A cram down is complicated to pull off in court, because the creditor will most certainly object, but an effective bankruptcy attorney can usually get the job done.

For homeowners, lien stripping is much more difficult to do and most courts will not allow first mortgage debt to be stripped. However, if a home has a second or third mortgage, or a home equity loan against it, and the first mortgage is greater than the value of the home, the "extra" loans can often be stripped off and discharged.

Tools for Delinquent Homeowners

Homeowners who have become delinquent (behind on their mortgage payments) have some special options under a chapter 13 bankruptcy. First off, the automatic stay stops any pending foreclosure proceedings, as long as the sheriff's sale hasn't already taken place, and buys the homeowner some time to work out an option to keep the house, or get out of the loan if they choose to.

One great tool under a chapter 13 bankruptcy plan is the ability to keep the home and use the monthly chapter 13 payment to "cure" mortgage arrears, which means they can catch up on all the missed payments over the length of the three to five year payment plan.

A bankruptcy lawyer will negotiate a loan modification during the case to reduce the interest rate and get more affordable terms for the homeowner. Lenders are much more likely to agree to a modified loan during a bankruptcy case, because they know the court will ensure they cannot get any deficiencies out of the homeowner.

The Bottom Line

Bankruptcy offers a lot of options for people to get real financial help. It can help protect property, stop creditor harassment, relieve most common types of debt and bring back the peace of mind knowing that your financial situation will be back under your control. No other option available to debtors even comes close to the effectiveness of US bankruptcy laws. An attorney can help you decide whether pursuing a bankruptcy is right for you, and help you begin the paperwork and bankruptcy process.

Next Steps

5. Your Property in Bankruptcy
6. Your Options: Chapter 7 vs. Chapter 13
7. Planning Your Bankruptcy Strategy

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