Many people use the terms bankruptcy and insolvency interchangeably for referring to a person or a company that is unable to pay off debts.
In Australia the words ‘bankrupt’ and insolvent’ are often used interchangeably and are taken to mean the same thing when referring to a person or a company that is unable to pay off debts. While the terms certainly refer to a challenging debt management situation, they mean different things with different legal consequences for bankrupt and insolvent individuals. So, it is important for you to know about the differences between bankruptcy and insolvency, along with their possible implications
Bankrupt and insolvent both essentially refer to a person (or company) that is unable to pay their due debts. However, whilst it’s correct that the accurate term to describe someone who can’t pay their debts is insolvent, bankruptcy is in fact a legal procedure for people who are insolvent.
Clear as mud? This post describes the key differences between bankruptcy and insolvency. Read on to find out more.
What is insolvency?
Insolvency (also known as personal insolvency) is a financial situation in which you are unable to pay your due debts. Being labeled as insolvent might sound bad, but the situation is not as dire as you might think. Many people have been through times when they became insolvent because of their inability to repay their debts. Insolvency is usually temporary, and you can regain solvency when your financial situation improves, and you pay off your overdue debts. According to the Australian Financial Security Authority (AFSA), there were 2,410 new personal insolvencies reported in the September 2022 quarter in Australia.
Being insolvent for a brief period, say, for a few months, might have less severe consequences than staying insolvent for years. Insolvency is a precarious situation to be in, so you should act quickly to get yourself out of the quagmire.
The common causes of personal insolvency include excessive use of credit, unemployment or loss of income or having to pay an unexpectedly large bill due to an emergency. Declaring insolvency, or that you are unable to pay your debts, provides a fair and orderly process for sorting out your financial affairs and making sure it doesn’t happen again, whilst providing for the repayment of debts, whole or in part, to your creditors.
While insolvency might be a sign of temporary deterioration in your financial situation, it can worsen if you don’t take remedial steps. If your insolvency prolongs, declaring bankruptcy is one of the many options you can consider.
What is bankruptcy?
Bankruptcy is a legal process wherein it is proclaimed that you are unable to pay your debts. Once you are declared bankrupt, you are absolved from most of your debts to allow you to start afresh and provide you with some relief. However, bankruptcy affects your life and can impact your income, business, and employment. You can check out our previous blogs for more information on bankruptcy here.
Bankruptcy has some serious financial consequences, usually lasts for 3 years and 1 day and stays listed on your credit report for five years. When you are declared bankrupt, you are appointed a bankruptcy trustee to oversee your financial affairs and administer your assets (such as property) for settling debts of unsecured creditors.
What are the differences between bankruptcy and insolvency?
The major difference between the two is that insolvency refers to a person’s financial state whereas bankruptcy refers to an insolvent person’s legal state. In other words, when you become insolvent, it means that you are simply unable to pay your due debts. To be declared bankrupt, you must undergo a legal process, whereas no legal process is required to declare a person insolvent.
Insolvency simply means that you are unable to repay your debts on time. If you remain insolvent for prolonged periods, you can choose to declare bankruptcy as a debt relief solution. You can either voluntarily file for bankruptcy, or your creditor can have you declared as bankrupt by a Bankruptcy Court.
Another important distinction between the two terms is that insolvency mostly applies to companies, whereas bankruptcy applies to individuals. In other words, when companies are unable to pay off their loans, they are considered insolvent, while individuals who declare they cannot repay their debts are considered bankrupt. In Australia, the Bankruptcy Act 1966 governs insolvency for individuals.
What are your options if you become insolvent?
When you are unable to pay your due debts, you become insolvent. You, then, have some legal ways to get yourself out of this situation as your creditors continuously demand their money from you. The Bankruptcy Act 1966 gives four options to an insolvent person to manage unpaid debts. The options are
- Personal insolvency agreement
- Debt agreement
- Declaration of intent
1. Personal insolvency agreement
A personal insolvency agreement is a legally binding agreement between you and your creditors. It is an option that allows you to make an arrangement between yourself and the companies you owe money to (your creditor) to settle the amount of your unsecured debts. The agreement could involve you paying part or all of your debts by instalments or as a lump sum.
A personal insolvency agreement (Part 10 or Part X), sometimes referred to as a PIA, is governed by the provisions of Part X of the Bankruptcy Act 1966 and administered by a registered trustee. The trustee takes control of your assets, such as your property, and makes an offer to pay a lump sum or instalments of your unpaid debts to your creditors.
It is suitable if you have exhausted all other avenues of debt solutions, are not eligible for a Debt Agreement and don’t want to file for Bankruptcy.
2. Debt agreement
A formal legally binding debt agreement, or Part IX agreement serves as a way to avoid bankruptcy as you agree to pay your creditors a portion of your total debt that you can afford over a period of time. It can be a flexible way to come to an arrangement to pay an agreed amount, with all your debts consolidated into an affordable payment to be made on agreed regular basis.
You typically pay an amount of less than what you owe, to finalise and settle your debt without becoming bankrupt. A debt agreement is sometimes referred to as a Part 9 or IX, and is arranged by a third party, known as your debt administrator. Debt agreements benefit borrowers and lenders alike as borrowers can pay back the amount that they can afford, while lenders can recover at least some part of their debts, which wouldn’t be possible in case a borrower filed for bankruptcy.
3. Declaration of intention to present a debtor’s petition
“Declaration of intention to present a debtor’s petition” is another possible way to get out of insolvency and avoid bankruptcy. The Bankruptcy Act of 1966 allows debtors to lodge a declaration of intention with AFSA, which gives debtors a 21-day protection period during which creditors won’t be able to contact borrowers to recover their dues. This provides borrowers with some time to streamline their finances or arrange funds for paying off their debts.
Bankruptcy is the least desirable debt relief solution. You can file for bankruptcy voluntarily by debtor’s petition, or your creditor can apply to the court for declaring you bankrupt. A trustee is appointed who manages your bankruptcy and has the authority to legally sell some of your allowable assets to settle claims of your creditors. With bankruptcy, you are discharged from paying most of your debts, but you have to endure its consequences.
You can learn more out more about formal debt solution options here.
What are the consequences of personal insolvency and bankruptcy?
If you become insolvent and you opt for either of the four legal options, your credit report will be impacted, your credit score will tumble, and your chances of getting further loans will diminish, along with other possible ramifications.
For example, if you enter into a personal insolvency agreement with your creditor, it will appear on your credit report for five years or longer, which makes it difficult for you to get new loans. Also, your details will forever appear on the National Personal Insolvency Index (NPII) index.
If you enter into a debt agreement with your lenders, you won’t be able to get new loans as the arrangement will be listed on your credit report for five years and will also appear on the NPII.
Bankruptcy lasts for three years and one day and stays on your credit report for two years from the date your bankruptcy ends or five years from the date you became bankrupt, whichever is later. If you file for bankruptcy, your overseas travel might be restricted, and you might be unqualified for some job, amongst other consequences.
From our discussion in the article, you can infer that insolvency is an individual’s inability to pay off due debts. Bankruptcy is one of the legal options, though arguably the least desirable one, that you can take to relieve yourself from unmanageable debts. Temporary insolvency might have less serious repercussions, but prolonged insolvency can get you in trouble. As part of your debt relief efforts, you have the options to either enter into a personal insolvency agreement (Part X agreement), debt agreement (Part IX agreement), DOI (Declaration of Intention to present a debtor’s petition), or file for bankruptcy. But all of the options have their negative ramifications.