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Debt itself is not necessarily a negative. Indeed, many economists will tell you that debt makes the world go round. When people are willing to lend out accumulated capital, it signals confidence in borrowers, in the economy, and in the integrity of the legal system–which lenders depend on to protect their interests.
Excessive debt is another matter entirely. It can cripple borrowers and stagnate economic activity. And when debt reaches the point that it can’t be serviced by borrowers, and has essentially zero chance of ever being repaid (absent intervention), bankruptcy is the only real option left.
Though the conditions imposed on borrowers are often harsh, bankruptcy laws relieve debtors of their legal responsibility to repay their debts. Often, this protection is designed to give borrowers enough breathing room to organize themselves and have a much better chance of eventually repaying their debts–in whole or in part.
There are two types of bankruptcies in the United States: liquidation, in which borrowers’ debts are “discharged” (or wiped out), and reorganization, where borrowers present a plan to the court describing how they plan to repay their creditors.
Liquidation bankruptcy is also known as “ordinary,” “straight,” or “Chapter 7” bankruptcy and can be invoked by both individuals and businesses. This is, by far, the most common type of bankruptcy claimed by individuals. Liquidation bankruptcy demands that an assigned trustee sell off the debtor’s assets to begin repaying his or her creditors.
Reorganization bankruptcy involving (most) individuals is known as Chapter 7 bankruptcy, while that involving smaller businesses is known as Chapter 13. However, when extraordinary levels of debt are involved–incurred by either individuals or businesses–the relevant bankruptcy law is Chapter 11. Family farmers are able to reorganize under Chapter 12.