How Does Bankruptcy Work? [Infographic]

When you’re in financial trouble, and unsure of what to do next, bankruptcy becomes an attractive option. “Declaring bankruptcy” is considered the ultimate financial do over. However, it doesn’t work as simply as many people like to think.

Below, is a helpful infographic that provides you with some insight into how American bankruptcy works:

from TotalBankruptcy.com

As you can see, individuals have two main choices (although in some cases Chapter 11 is an option for individuals):

1. Chapter 7: This is what most people think of when they think of bankruptcy. You liquidate all non-exempt assets and then whatever is left just disappears.
2. Chapter 13: You can keep more of your assets. Instead of wiping out your debt, though, a three to five year payment plan is worked out, based on your ability to pay. Some of the debt is forgiven in this way in many cases.

It’s harder to file for Chapter 7 bankruptcy, since there are stricter conditions since your debt is wiped out. If a judge thinks that you are likely to be able to make some of your payments, you will have to file for Chapter 13 bankruptcy. Make sure you carefully consider your situation before making your choice.

How Many People Go Bankrupt?

According to the infogrpahic above, 2011 saw 1.4 million bankruptcy filings. Interestingly, the number of filings went down 12% from 2010 to 2011. Declines in bankruptcies might be a sign that things are improving for ordinary Americans, who have felt the effects of the recent global financial crisis and recession for years now.

I would have liked more information on why people declare bankruptcy, however. A little digging around shows that some of the reasons people declare bankruptcy include job loss, household consumption (high debt levels), and medical costs. Studies have documented that in more than 60% of bankruptcy cases, medical costs are a contributing factor.

However, as with all things finance, you can’t blame bankruptcy on any one thing in most cases. A major illness or a job loss might just be what put an indebted household over the edge.

The Need for an Emergency Fund

Whenever I see infographics like this, it reminds me of the importance of an emergency fund, as well as the importance of paying down debt. An emergency fund can help you weather some of the unexpected financial storms that come your way. When you have an emergency fund, you don’t need to turn to debt as quickly when you lose your job. You have something to draw on to make medical payments.

While an emergency fund may not solve all your problems, and you still might be vulnerable (what if your emergency fund isn’t big enough?), having money set aside can be a real help to you — and help you prepare. Build up an emergency fund to help you avoid bankruptcy in the future.

Also, consider paying off some of your debt. The debt you have only further strains your finances and causes problems. Instead, work toward paying off as much debt as you can now. Combine that with efforts to build an emergency fund, and you’ll feel less pressure to declare bankruptcy when unexpected catastrophes force your hand.