History of Bankruptcy (Part Two)

This is part two of two on the history of bankruptcy.  This post covers the Bankruptcy Law of the United States.  The previous post on this topic covered the ancient history of bankruptcy and its origins.  Like the last post on this topic this post is an excerpt from my book "Should I File: A Definitive Guide to Bankruptcy," which can be bought by clicking the link below. 

The first act of Congress was the Bankruptcy Act of 1800, and while that act was repealed and amend multiple times before the current law was enacted in 1938 the basic concept remains very much the same.  There been several changes to the Bankruptcy laws since 1938 but in general the law remains the same.

Many readers will recall the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.  When the bill passed in to law the news media, fueled by bankruptcy attorneys looking for a quick buck made it sound as if once the law took effect in October of 2005 it would become nearly impossible to file a bankruptcy and that if you were successful in qualifying you would still spend many years in debt and in many cases would lose all of your personal property.   After the law passed and was signed into law in April of 2005 by then President George W. Bush, these claims were repeated so often that many of them persist today.

Most aspects of the new law did not take effect until October and the period of time between April and October of 2005 became a virtual gold rush for bankruptcy attorneys many of whom filed more than ten times their usual number of bankruptcy.  One such attorney I talked to told me that he filed over 400 bankruptcies in the 5 days before the law took effect.  This mad rush of filings was most likely due to the misconception that after October of 2005 Bankruptcy as we know it would no longer exist.  Ironically many of the attorneys practicing in this area fell for their own hype.  I know of several former bankruptcy attorneys so scared of the new law that they stopped filing them all together.

In retrospect, the changes in the Bankruptcy law did little to prevent the protection of the code.  The most significant change from the average debtors perspective is the creation of an income based test, known as the means test.  The means test prevents certain high income debtors from discharging (eliminating) all of their debt.  In the case of high income debtors or debtors who make more than the means test allowable amounts (which varies by state) there is a requirement that make their best efforts to pay back some portion of their debts.  The amount that they pay back is determined by among other things their ability to pay after allowances for reasonable living expenses.  This type of repayment bankruptcy is known as a Chapter 13 Bankruptcy.  

                                                                  

History of Bankruptcy (Part One)

This post is part one of two and covers primarily the ancient history of Bankruptcy.  This is an excerpt from my Book "Should I File: A Definitive Guide to Bankruptcy" If you find the information on this site useful please consider purchasing my book which covers the material on this site in more detail.  It is full of examples and case studies which will aid you in developing a more complete understanding of the issues involved in Bankruptcy. 

A long long time ago:

Before the modern era there was no official bankruptcy law.  In many cases, failure to pay your debts resulted in debtor’s prison, slavery or even death.   Even after the idea of bankruptcy came about the consequence of bankruptcy was often imprisonment or death.  Genghis Kahn for example is said to have included a provision in his Bankruptcy law that mandated the death penalty to anyone who became bankrupt three times.  And while it may seem that the modern consequences of Bankruptcy are bad you can be assured that they will not include death.  

Many of the world’s major religions have mechanisms built in to alleviate or even eliminate debt.  These mechanisms are found in the Bible, the Torah, and the Qur’an.  The Torah and the Old Testament included a year of Jubilee when most or all debts were forgiven.  This concept forms the basis of modern day chapter 7 bankruptcy where the debtor’s debts are forgiven often completely. 

The second chapter of the Qur’an (Sura Al-Baqara) Verse 280 states that “…if someone is in hardship, then let there be postponement until a time of ease.”  This statement resembles modern day chapter 13 bankruptcy where debtors propose a plan to repay their debts on a schedule that it more affordable than the current schedule. 

 Modern bankruptcy first leapt on to the scene in Britain with the Bankruptcy act of 1542 (34 and 35, Henry VIII, c.4).  In the United States of the first acts of the Federal Government was to create bankruptcy protection.  In fact, the power to regulate Bankruptcy in the United States was granted by the Constitution when it was ratified in 1789.  In Article I, Section 8, Clause 4, Congress was granted the power to legislate “uniform laws on the subject of Bankruptcies” throughout the several States.  

                                                                

Not just your credit score

           This post is a bit longer than my typical post but I think that you will find it helpful.  This post describes in some detail the inner workings of the credit decision made by lenders.  So if you are trying to borrow money for any reason or you think that you might consider buying something on credit in the future then you may find this post helpful.  As always keep in mind that every situation is different and I can not offer legal advice over this blog.  Make sure you seek out the information you need before making an major financial decision. 

 There are three categories of information that are relevant to an individuals credit worthiness.  The first category deals primarily with the repayment of past debts.  This is reflected in your credit score.  The second category deals with your income and the third with you current liabilities.  (ie how much money you owe). 

            It’s the balance between these three things that make up the true picture of your individual creditworthiness.  When a lender evaluates a person’s credit they do look at the score, but they also look at the debt to income ratio. 

Debt to Income Ratio = Total Debt/ Total Income

            The lower the product of this formula, the better your overall financial position is.  For example if you owe $1000 and make $100,000 dollars a year then your debt to income ratio would be calculated in the following manner. 

Example #1: Debt to Income Ratio = $1000/$100000 = .01

          This means that for this individual their total debt is 1/100^th of their gross annual income or more clearly stated their gross annual income is 100 times their total debt load.  A very manageable number regardless of how much debt or income a person has.  It wouldn’t matter if the person had one million dollars in debt if their ratio was still .01 then they could easily afford to pay their debt.  Of course to keep that ratio they would have to be making one hundred million dollars a year. 

Example #2: Debt to Income Ratio = $50,000/$100000 = .5

            In Example # 2 the person’s income remained $100,000 a very respectable income, but their total debt increased to $50,000, which caused their debt to income ratio to rise to .5.  Even at this level, they probably can afford to pay their debts but as you can see the higher the ratio the more difficult it becomes to pay one debts. 

            Now that we have seen how this ratio is calculated and understand why it’s important we can see why it is that lenders want the information that they require.  Interestingly, while filing Bankruptcy hurts your credit score (which is calculated primarily on past repayment of debt), it significantly improves your debt to income ratio, arguably making you a much better credit risk after Bankruptcy. 

Let’s take a look at a more typical example, where the individual considering Bankruptcy has a car that they owe $15,000 on and $50,000 dollars in credit card debt.  In this scenario let’s assume an income of $40,000 per year

EXAMPLE # 3: Debt to Income Ratio = $65,000/$40000 = 1.63

            As you can see, this person is probably struggling to make their payments with a ratio significantly above one.  Let’s assume that they chose to keep their car when they file Bankruptcy.  Which means that post Bankruptcy, this individual will owe $15,000 on their car and will have no credit card debt.  The Bankruptcy should not affect their income. 

EXAMPLE #3 After BK: Debt to Income Ratio = $15,000/$40000 = .38

          As you should be able to see the Bankruptcy process greatly improves their debt to income ratio making them a much better credit risk.  Many banks and lenders who understand this trend are quite willing to extend credit to individuals shortly after they file Bankruptcy. 

            When excluding your home it is a very good idea to keep your debt to income ratio as low as possible.  For a variety of reasons the numbers are a little different when a home mortgage is involved, which is why I recommend calculating your debt to income ratio both with and without your mortgage included.

            Example #4 illustrates the impact of a home mortgage on this calculation.  In this scenario, the individual has a home mortgage of $150,000, credit card debt of $15,000 and income of $50,000 a year. 

I go in to these issues in much more detail in my book which you can buy on amazon by clicking the link to it below.

                                                               

Defining Chapter 7 and Chapter 13

While there are many different types of Bankruptcies.  On this site you will most often see references to Chapter 7's and Chapter 13's. 

Chapter 7 Bankruptcy is by far the most common form of individual filing some people refer to it as Liquidation or total Bankruptcy in this site it will be most often referred to as a Chapter 7.   You also see references to Chapter 13 Bankruptcies which are also called repayment or restructuring Bankruptcies. 

These names we use derive from the section of the United States Federal Code specifically 11 USC Chapter 7 and 11 USC Chapter 13.   There are other chapters of bankruptcy but they generally involve complex business restructuring or specific entities like the Chapter 9 which is for cities and states or the Chapter 12 which is for certain farm restructuring programs. 

In simple terms all you really need to know is that a Chapter 7 allows the debtor to eliminate most debts and keep most of their stuff without making any kind of payments to the Trustee.  And that in a Chapter 13 the debtor enters into a plan to repay some part of their debts and after a period of time typically between 36 and 60 months any remaining debt that they have can be discharged. 

Understanding the differences between these chapters is fundamental.  I highly recommend learning as much as you can about these difference before entering into any type of Bankruptcy.   

Simple definitions

Chapter 7:  Most common type of Bankruptcy available for business and for individuals.  In most cases individuals who file this chapter can keep all of their assets and are not required to pay any of their debts, it is for this reason it is sometimes also referred to as “Total Bankruptcy”

Chapter 13: Is a type of Bankruptcy only available to real people (businesses cannot file this type) It is a repayment plan Bankruptcy that last between 3 years and 5 years, with the debtor typically paying monthly or weekly payments.  At the conclusion of the 3-5 year period any remaining debt can be discharged. 

These definitions and many others appear in the glossary at the back of my book, "Should I File: A Definitive Guide to Bankruptcy.  As you read this site it may be helpful to refer to the book's glossary which can help to ensure that you understand the vocabulary used on this site.  This understanding is critical to understanding the Bankruptcy process.  If you have not yet purchased my book it can be bought on Amazon by clicking the link below.