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Insolvency and bankruptcy may sound like synonyms, but there are actually some key differences between these two terms. While both describe a situation where a person or company is unable to pay their debts, bankruptcy is a legal declaration – it’s what can happen if insolvency doesn’t get resolved. Here’s a closer look at bankruptcy vs insolvency, how each situation can happen to a person or small business, and the pros and cons of formally filing for bankruptcy.
What Is Bankruptcy?
Bankruptcy is a legal lifeline that an individual or company can use when they are unable to pay their debts. Debtor’s file for bankruptcy through the federal court system, and in return they receive aid in 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 who 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 when a debtor’s assets are liquidated. Bankruptcy can have a big effect on a debtor's financial record, however, particularly their credit scores. Businesses that file for bankruptcy may have difficulty getting approved for many types of business loans during the period that the bankruptcy remains on their credit reports.
How Does Bankruptcy Work?
Before a debtor can file for bankruptcy, there are a few requirements they need to meet. First, they need to demonstrate that they can’t repay their debts. (The courts can choose to toss out bankruptcy cases when they believe an individual has enough assets to cover their debts.) They also need to get credit counseling with a government-approved credit counselor, who can help them assess their assets and determine if there are better alternatives to bankruptcy. If, ater receiving counseling, the debtor moves forward with their bankruptcy case, they’ll need to decide what type of bankruptcy to file (more on that below).Bankruptcy provides an automatic stay of collections and immediate relief from creditors who must stop collections proceedings while your 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.
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. 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, such as cars needed for transportation, basic household furnishings, and the tools needed for work. Once these 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 child support, court-ordered alimony, 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/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 the terms of their debts with creditors, such as 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 business owners 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 7 years, and those who find themselves swamped by debt yet again can file for this chapter after just two years.
What Is Insolvency?
Insolvency is 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 bankrupt. However, if they are bankrupt, they are, by definition, insolvent. Insolvent individuals and businesses have options to help them pay back their debt. They could borrow money, increase income, or negotiate repayment with creditors. If these options fail, bankruptcy may be the only remaining possibility.
How Does Insolvency Work?
There are two different types of insolvency. Cash-flow insolvency, or illiquidity, occurs when an individual doesn’t have the money to pay off their debts. Balance-sheet insolvency occurs when total debts exceed the value of total assets. A business could be cash-flow insolvent while being balance-sheet solvent if they have assets they could sell that are worth more than their debt. The reverse is also possible: A business can be balance-sheet insolvent (debts exceed assets), but cash-flow solvent if it's able to meet its immediate financial obligations. In fact, many businesses operate this way.When an insolvent individual or business is unable to meet their debt obligations, creditors will 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, the lender may start foreclosure proceedings on their home. If these go through, the individuals will lose their home, and the bank will sell it to help recoup the debt. For unsecured debt, such as credit cards or personal loans, lenders may send the debt to a collections agency, which may then hound the individual in an effort to get them to pay.
Insolvency vs. Bankruptcy
Insolvency and bankruptcy are not the same thing, but they are very much related. Here’s a quick look at the similarities and differences between the two terms.
Similarities
The main characteristic that insolvency and bankruptcy share is the inability to pay off debts. This may mean that an individual or business does not have the cash to pay them off or enough assets to liquidate to cover the debt. Bankruptcy can damage a person’s or business’s credit score for up to 10 years, making it more difficult for a filer to acquire credit in the medium-term. Insolvency can also damage a debtor’s credit if they are unable to pay their bills on time (though not nearly as much as bankruptcy). A delinquent payment will remain on a person’s or business’s credit report for seven years. While bankruptcy is 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 state of being, whereas bankruptcy is a legal designation. Someone who is insolvent has not necessarily filed for bankruptcy. There may be other tactics they can use to pay down their debt. Insolvency can often be reversed by negotiating with creditors or if an infusion of cash, such as an inheritance, bonus at work, or large business payment, is coming down the pipeline. Someone who has filed for bankruptcy has determined that they have no other options to pay off their debt. The court will then determine if they have any assets that they can sell. Proceeds from the sale are given to creditors, and debts are discharged. Here’s a look at bankruptcy vs insolvency at a glance:
Similarities Between Insolvency and Bankruptcy
Differences Between Insolvency and Bankruptcy
Person or business doesn't have enough money to repay debt to creditors
Insolvency is a financial state; bankruptcy is a legal designation
Debtor may not have enough assets to liquidate to cover debts
Insolvent individuals and businesses may have other strategies to help them clear their debts; bankrupt entities do not
Both can impact credit (but bankruptcy much moreso)
Insolvency can be reversed; once the bankruptcy is declared, there is no going back.
Pros and Cons of Filing for Bankruptcy
Bankruptcy can be a solution to insolvency, but it comes with a number of downsides. Here’s a look at the pros and cons.
Pros of Filing for Bankruptcy
Stay of collections and repossessions: When you file for bankruptcy, there is an automatic stay of collections. Creditors must hit the pause button on collecting debt, repossessing property, garnishing wages, lawsuits, and 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 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 and alimony, tax liens, and student loans.
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 could lose personal or business items of value that must be sold off 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 Bankruptcy
Cons of Filing for Bankruptcy
Stay of collections and repossessions
Puts a negative mark on your credit report, making it harder to securing new lines of credit for many years
Debts will be settled for less than what you owe
Not all debts can be discharged, including student loans, tax liens, and court ordered child support and alimony
A chance to hit the restart button and start rebuilding your financial life
You may lose assets that the court says need to be liquidated to pay creditors
The Takeaway
Though people may say they are “bankrupt” when they are too broke to pay off their debts and obligations, it’s not actually the correct word. The right term is insolvent. In order to be bankrupt, the person must first file a petition with the court declaring their bankruptcy.Insolvency that can be solved results 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.
3 Small Business Loan Tips
Generally, it can be easier for entrepreneurs starting out to qualify for a loan from an online lender than from a traditional lender. Lantern by SoFi’s single application makes it easy to find and compare small business loan offers from multiple lenders.
If you are launching a new business or your business is young, lenders will consider your personal credit score. Eventually, though, you’ll want to establish your business credit.
If you need to borrow money to cover seasonal cash flow fluctuations, a business line of credit, rather than a term loan, provides the flexibility you likely need.
Frequently Asked Questions
What do you lose if you have to declare bankruptcy?
How much debt do you need to be in to file for bankruptcy?
What does financially insolvent mean?
Photo credit: iStock/golubovy
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About the Author
Austin Kilham
Austin Kilham is a writer and journalist based in Los Angeles. He focuses on personal finance, retirement, business, and health care with an eye toward helping others understand complex topics.
