(MoneyWatch) It's called the "10 year mistake" by credit counseling services. Financial advisors say to avoid it at all costs. But, according to the American Bankruptcy Institute, filing for bankruptcy was unavoidable for 1.46 million individuals and 36,000 businesses in 2011. Although these levels are historically high, the good news is that individual bankruptcy filings have declined 8 to ten percent over the past year.
Bankruptcy is a federal court process that is designed to help individuals eliminate overwhelming debts or repay them under the protection and supervision of the bankruptcy court. There are two general categories, "liquidation" and "reorganization".
About 75 percent of the individuals who file for bankruptcy do so under Chapter 7, which is a form of liquidation bankruptcy. Basically the process involves completion of forms and submission of a petition to the court. Upon review and approval, an "automatic stay" is imposed on all creditors, prohibiting them from collecting debts owed to them until contacted by the court. Creditors are then informed of the repayment terms, if any.
Certain property is exempt in bankruptcy which individuals are allowed to keep, while other assets must be turned over to the court's trustee to be sold and the proceeds used towards paying some of the creditors' claims. One notable exempt asset is an individual's account in an employer's retirement plan. Under government regulations, these assets are exempt from liquidation to pay creditors. For this reason, leaving assets in a 401(k) or other retirement plan or an IRA may be advised versus taking distributions or loans from these accounts.
Chapter 13 is another form of bankruptcy, which is also referred to as "reorganization" or "wage-earner" bankruptcy. This version includes a repayment plan which describes how the debts will be repaid over the next three to five years and a trustee is assigned to oversee the repayment process. Creditors are permitted to comment on the repayment plan. After approval by the court, whatever debt is left after the terms of repayment is discharged.
Some of the most common reasons for filing for bankruptcy include divorce, unexpected and uninsured health problems and loss of a job. The personal stories range from younger individuals overextending themselves on credit cards when buying their first house to older folks getting caught in high interest rate loans for home repairs such as siding or replacement windows. In most all cases, financial problems begin with access to more credit than can be handled and under terms where interest rates are higher than average.
Check back later this week when I'll write about the consequences of filing bankruptcy and how folks who do it can move forward financially.