Over one million U.S. consumers will declare bankruptcy in 2008 according to the American Bankruptcy Institute. Bankruptcy can relieve struggling consumers of their debts, but it also creates financial consequences that can last 10 years. Indebted or not, understanding how bankruptcy works can help you make smarter credit decisions for years to come.

Personal bankruptcy 101
When an individual simply cannot meet financial obligations, he or she may declare bankruptcy. By doing so, the federal court system becomes an intermediary between the filer and his or her creditors. Bankruptcy helps the struggling consumer free up money for essential expenses like rent and food, but also ensures that creditors get at least some of what they are owed.

Typically, consumers file bankruptcy as a result of unsecured debt such as credit cards or medical bills. Secured debts, such as mortgages and auto loans, cannot be discharged during a bankruptcy. If a consumer does not repay a secured loan, the creditor repossesses the secured asset (e.g. the house or car) that is tied to the loan.

Two types of bankruptcy
There are two types of consumer bankruptcy: Chapter 7 and Chapter 13. Under Chapter 7 bankruptcy, the filer's property is sold off to repay his or her debts. After the property is sold, the court discharges any remaining unsecured debts (like credit cards), and the filer does not have to repay them.

Under Chapter 13 bankruptcy, a filer must repay a portion of his or her unsecured debts over three to five years based upon their income. Any remaining sums are discharged. In 2005, Congress enacted a law that makes it more difficult for consumers to file bankruptcy—Chapter 7 bankruptcy in particular. Now, to be eligible to file for either kind of bankruptcy, a consumer must first participate in a credit counseling program. To be eligible to file for Chapter 7 bankruptcy, consumers must then pass the "Chapter 7 means test."

To file Chapter 7 bankruptcy, a filer's gross annual income must be less than the median income in the filer's state of residence. Second, the filer must determine how much "disposable" income he or she will have over the next five years based upon a complicated IRS formula. If the filer's disposable income is less than $6,000 over five years ($100 per month), he or she can file for bankruptcy under Chapter 7.

Benefits of bankruptcy
There are two primary benefits to bankruptcy filers: 1) The total amount a filer owes is either eliminated or reduced and 2) Immediately upon filing for bankruptcy, the court issues an automatic stay prohibiting creditors from contacting the filer and freezing any legal actions against the filer. The automatic stay will—at least temporarily—prevent the filer from being evicted, having utilities shut off, or having property repossessed. The reason the stay is ordered is so that the bankruptcy court can have a chance to hear from all of the creditors to whom the filer owes money and then systematically and equitably distribute any repayments collected among the creditors.

Downfalls of bankruptcy
To those under a mountain of debt, bankruptcy can be enticing. There are several negative consequences to filing bankruptcy, however, that potential filers must consider:

1. Bankruptcy will limit your credit. Bankruptcy is not necessarily the kiss of death to your credit report, but it's far from a good thing. Chapter 13 bankruptcy stays on your credit report for seven years and Chapter 7 for ten, during which time getting new credit will be difficult.
2. Bankruptcy is a permanent record. The bankruptcy will eventually disappear from your credit history, but that doesn't mean it's gone. Bankruptcies are public records, meaning that for the rest of your life, anybody who checks can see that you filed bankruptcy. It may, for example, come up during background checks for a new job. While not debilitating, it's certainly embarrassing.
3. Bankruptcy costs money. Oddly enough, filing for bankruptcy is anything but cheap. There is a $274 filing fee for Chapter 13 bankruptcy and a $299 fee for Chapter 7. Plus, an attorney will charge anywhere from several thousand dollars to tens of thousand of dollars in fees, depending upon the complexity of your case.

Personal bankruptcy is a safety net that the government provides for citizens that encounter dire financial circumstances. While the process can work for those who need it, bankruptcy should never be seen an "escape hatch" for consumers who have simply spent themselves into too much debt. Those that think that way file for bankruptcy one year and find themselves in debt all over again the next.

Plenty of additional information on bankruptcy is available online, but be careful, as there is a lot of unreliable information from law firms and other businesses trying to scare readers into using their services. I recommend the bankruptcy resources on NoLo.com, which also features a directory that can help you find a qualified attorney.