Table of Contents
While both insolvency and bankruptcy are terms that describe a situation where a person or company is unable to pay their debts, bankruptcy is a legal declaration – it’s what can result if insolvency isn’t resolved.
Keep reading for a closer look at bankruptcy vs. insolvency, how a person or small business might experience each situation, and the pros and cons of formally filing for bankruptcy.
Key Points
• Insolvency is a financial state that occurs when you can’t pay your debts, while bankruptcy is a legal declaration filed through federal court.
• Chapter 7 bankruptcy involves liquidating assets to pay creditors, Chapter 11 allows businesses to restructure finances, and Chapter 13 enables individuals to create repayment plans.
• Cash-flow insolvency occurs when liquid funds aren’t sufficient to allow a business to pay its debts, whereas balance-sheet insolvency means total debts exceed total asset value.
• Alternatives to bankruptcy include debt restructuring with creditors, consolidating debts for better terms, selling non-essential assets, or strategically reducing business operations.
• Bankruptcy establishes court-supervised debt resolution but also creates a long-lasting negative impact on credit reports for several years.
What Is Bankruptcy?
Bankruptcy is a legal lifeline that an individual or company can use when they’re unable to pay their debts. Debtors file for bankruptcy through the federal court system, and in return they receive help and direction for discharging their debts or making a plan to repay them. Individuals, couples, corporations, and small businesses can file for bankruptcy.
Bankruptcy is designed to give individuals and businesses that are unable to pay their debts a fresh start, while also giving creditors a chance to recoup at least some of what they are owed.
Bankruptcy can have a major effect on a debtor’s financial record, particularly their credit scores. Businesses that file for bankruptcy may have difficulty getting approved for many types of business loans as long as the bankruptcy remains on their credit reports.
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How Does Bankruptcy Work?
Either an individual or a business can file for bankruptcy with the bankruptcy court if they find that they are unable to pay their debts. There are different kinds (chapters) of bankruptcy, and debtors will need to apply for a specific kind. While debtors generally don’t have to demonstrate insolvency, they will need to provide relevant documents to show their income and debt. If the court finds a debtor ineligible for that chapter, it can dismiss their request or suggest converting their case to another chapter.
Eligibility requirements can be complicated, which is one reason it may be a good idea to work with a bankruptcy lawyer if you’re contemplating bankruptcy.
An individual debtor (including a sole proprietor) filing for bankruptcy will also need to get credit counseling with a government-approved credit counselor within 180 days before filing. The counselor can help them assess their assets and determine if there are better alternatives to bankruptcy.
Bankruptcy provides an automatic stay of collections and immediate relief from creditors, who must stop collections proceedings while the case is active. The courts will look at the debtor’s assets and decide how much they can reasonably pay and which debts they don’t have to pay.
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Types of Bankruptcy
The three main types of bankruptcy for individuals and businesses are Chapter 7, Chapter 11, and Chapter 13.
Chapter 7 Bankruptcy
Also known as “straight bankruptcy” or “liquidation bankruptcy,” Chapter 7 bankruptcy is the most common type of bankruptcy. Overseen by a court-appointed trustee, it entails the selling or “liquidating” of an individual or business’s assets to distribute to creditors. Certain assets are exempt from this sale, however. These vary by state but can include things like cars needed for transportation, basic household furnishings, and the tools needed for work.
Once the assets are liquidated and the debtor has given what money they can to their creditors, the rest of their debt is discharged. However, there are a few exceptions — an individual is still on the hook for debts like child support, taxes, and student loans.
A Chapter 7 bankruptcy will stay on the debtor’s credit report for 10 years after the filing date. And if that person or business gets in over their head again, they won’t be able to file for this chapter for another eight years.
Chapter 11 Bankruptcy
Chapter 11 bankruptcy is designed to help struggling businesses restructure their finances so they can remain open. With this type of bankruptcy, a debtor is able to remain in control of their business and renegotiate with creditors the terms of their debts, potentially modifying interest, payment due dates, and other terms. It can sometimes even erase debt entirely.
Chapter 11 bankruptcy allows a business to stay intact and come out the other side as a healthy business. However, it can be the most complex of all the bankruptcy chapters. It also tends to be the most expensive type of bankruptcy proceeding.
Chapter 13 Bankruptcy
Chapter 13 bankruptcy may be an option for individuals or owners of sole proprietorships who have a regular income stream. It allows the debtor to keep their property and develop a new payment plan to pay back either part or all of their outstanding debts over three to five years. A Chapter 13 bankruptcy stays on an individual’s or business’s credit report for seven years, and those who find themselves swamped by debt yet again can file for this chapter after just two years.
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What Is Insolvency?
Insolvency occurs when an individual or business is unable to pay outstanding debts to creditors or banks due to lack of funds. A person or company can be insolvent without going into bankruptcy.
Insolvent individuals and businesses have options to help them pay back their debt. They could borrow money, increase income, or negotiate repayment with their creditors. If these options fail, bankruptcy may be the only remaining possibility.
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How Does Insolvency Work?
Insolvency is not a legal proceeding. It may sometimes be possible to recover from insolvency informally with creditors, without filing for bankruptcy. However, insolvency can often result in a company or individual filing for bankruptcy.
When an insolvent individual or business is unable to meet their debt obligations, creditors may begin efforts to collect their due. At this point, insolvency can become a real problem.
For example, if an individual holds secured debt, such as a mortgage, and can’t pay, the lender may start foreclosure proceedings on their home. If these go through, the individual could lose their home, since the bank could sell it to help recoup the debt. With unsecured debts, such as credit cards or personal loans, lenders may send the debt to a collections agency, which might then hound the individual in an effort to get them to pay.
Types of Insolvency
There are two different types of insolvency: Cash-flow insolvency and balance-sheet insolvency. A debtor might experience just one or both of them.
Cash-Flow Insolvency
Cash-flow insolvency, or illiquidity, occurs when an individual doesn’t have the cash to pay off their debts as they come due. They may, however, have assets in other, non-liquid forms, like real estate.
In other words, it’s possible for a company or person to be cash-flow insolvent even if they have assets they could sell that are worth more than their debt.
Balance-Sheet Insolvency
Balance-sheet insolvency occurs when a company’s or individual’s total debts exceed the value of their total assets, no matter what form those assets are in or how liquid they are.
A business can be balance-sheet insolvent (debts exceed assets), but cash-flow solvent if it’s able to meet its immediate financial obligations.
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Insolvency vs Bankruptcy
As we’ve seen, insolvency and bankruptcy are not the same thing. However, they can be closely related. Here’s a quick look at similarities and differences between the two terms.
Similarities
The main characteristic that insolvency and bankruptcy share is the debtor’s inability to pay off debts. This may mean that an individual or business doesn’t have the cash to pay them off as they come in or that they don’t have enough assets, including those that they could liquidate, to cover their debt.
Bankruptcy can damage a person’s or business’s credit score for up to 10 years, making it more difficult for the filer to acquire credit in the medium term. Insolvency can also damage a debtor’s credit as a result of being unable to pay their bills on time — though typically this would not be nearly as significant as bankruptcy. A delinquent payment will remain on a person’s or business’s credit report for seven years.
While bankruptcy can be much more damaging, both insolvency and bankruptcy can hurt your chances of approval when applying for a small business loan.
Differences
The main difference between insolvency and bankruptcy is that insolvency is a financial state, whereas bankruptcy is a legal designation. Someone who is insolvent has not necessarily filed for bankruptcy, as there may be other tactics they could use to pay down their debt. Insolvency can sometimes be reversed by negotiating with creditors or with an infusion of cash, such as an inheritance, bonus at work, or large business payment.
A person or business that has filed for bankruptcy typically has no other options to pay off their debt. Filing for bankruptcy means that the business will need to work with a trustee and/or its creditors on next steps, depending on the type of bankruptcy.
Here’s a look at bankruptcy vs insolvency at a glance:
| Similarities Between Insolvency and Bankruptcy | Differences Between Insolvency and Bankruptcy |
|---|---|
| A person or business doesn’t have enough money to repay its debts to creditors. | Insolvency is a financial state; bankruptcy is a legal designation. |
| A debtor may not have enough assets to liquidate to cover debts. | Insolvent individuals and businesses may have other strategies to help them; those who declare bankruptcy likely don’t have those options. |
| Both can impact credit (but bankruptcy much more so). | Insolvency can be reversed; once bankruptcy is declared, there is no going back |
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Pros and Cons of Filing for Bankruptcy
Bankruptcy can be a solution for insolvency, but it comes with a number of downsides. Here’s a look at the pros and cons.
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Pros of Filing for Bankruptcy
• Stay of collections and repossessions: When you file for bankruptcy, there’s an automatic stay of collections. Creditors must hit the pause button on collecting debt, repossessing property, garnishing wages, filing lawsuits, and making phone calls.
• Debt relief: Your creditors will likely be forced to accept whatever payment is determined in your bankruptcy case, including no payment. You may be able to discharge most of your unsecured debt, including credit cards, personal loans, and medical bills.
• A chance to start over: Once bankruptcy proceedings are over, an individual or business can begin to rebuild their finances and reestablish good credit.
Cons of Filing Bankruptcy
• Your credit score will take a hit: A Chapter 7 bankruptcy will remain on your credit report for 10 years, while a Chapter 13 bankruptcy stays on your report for seven years. During that time, it will likely be much harder to secure new loans or lines of credit, as lenders may see the bankruptcy filing as a red flag.
• Some debts may remain: While you may be able to discharge most unsecured debt, other debt can’t be wiped out. You must still pay child support, tax liens, and student loans, for example.
• You could lose assets of value: Depending on which type of bankruptcy you qualify for, your income, and how much equity you have in your assets, you might lose personal or business items of value if they must be sold to pay creditors.
Here’s a look at the pros and cons of filing for Chapter 7 bankruptcy at a glance:
| Pros of Filing for Chapter 7 Bankruptcy | Cons of Filing for Chapter 7 Bankruptcy |
|---|---|
| Bankruptcy triggers a stay of collections and repossessions. | It puts a negative mark on your credit report, making it harder to secure new loans or lines of credit for many years. |
| Debts may be settled for less than the amount you owe. | Not all debts can be discharged, including student loans, tax liens, and child support. |
| You get a chance to hit the restart button and start rebuilding your financial life. | You may lose assets if the court determines they need to be liquidated to pay creditors. |
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Alternatives to Bankruptcy
If your company is experiencing insolvency or even just approaching it, that doesn’t mean that you will necessarily have to file for bankruptcy. There may be options that can help your business recover its footing and allow you to avoid bankruptcy. Some possible alternatives might be:
Debt restructuring.You can ask your creditors if they would be willing to renegotiate the terms of your loans in a way that would make them easier for you to repay. For instance, they might reduce your interest rate or extend your loan term, which could lower your monthly payments.
Debt consolidation. Business debt consolidation involves taking out a large loan to pay off all your current debts. This can simplify your payments but will save you money only if you obtain a lower interest rate or other more advantageous terms on the new loan.
Selling assets.If your company owns assets that aren’t necessary to its core operations, liquidating them could give you a cash infusion that might help you manage debts.
Reducing the size of your business. It may seem counterintuitive, but retrenching and limiting or even decreasing the services and/or goods your business offers may allow you to focus your efforts and control your costs more effectively.
The Takeaway
Though people may say they’re “bankrupt” when they are too broke to pay off their debts and obligations, that’s not the correct word. The right term is insolvent. In order to be bankrupt, the individual or business must first file a petition with the court declaring their bankruptcy.
Insolvency that can’t be resolved may result in bankruptcy. And, while filing for bankruptcy comes with a host of cons, it also provides a chance to make a fresh start, rebuild your credit, and once again have an opportunity to take out loans and lines of credit for yourself or your business.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What do you lose if you have to declare bankruptcy?
When you declare bankruptcy, you may have to sell certain assets to help settle debts with your creditors. Additionally, the bankruptcy will be a negative mark on your credit report for seven years when you file Chapter 13 bankruptcy or 10 years when you file Chapter 7 bankruptcy.
How much debt do you need to be in to file for bankruptcy?
While there are eligibility rules for the different types of bankruptcy, federal bankruptcy law doesn’t specify any minimum debt amount to file a bankruptcy case.
What does financially insolvent mean?
Individuals or businesses that are financially insolvent either do not have the cash flow to cover their debts or have a total debt greater than the total value of their assets. Being Insolvent does not automatically mean that a person or business is bankrupt.
Can you be insolvent without filing for bankruptcy?
Yes, it’s possible to be insolvent but not file for bankruptcy. If you or your business faces insolvency, you may be able to cover your debts by selling unnecessary assets, consolidating your debt to get more favorable terms, or renegotiating your debt terms, if your creditors are willing.
What are the consequences of insolvency vs. bankruptcy?
Insolvency doesn’t have any defined consequences, though not paying your bills can impact your credit negatively and ultimately lead to bankruptcy. Declaring bankruptcy results in the court establishing a plan for you to pay some or all of your debts – which may require the sale of some of your assets – but will also appear on your credit report for a number of years.
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