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Chapter 7 vs. Chapter 13 Bankruptcy
By Peter Burns MONEY RESEARCH COLLECTIVE
Filing for bankruptcy should be a last resort, but it can give you a fresh start. There are different kinds of bankruptcy you can file; the one you choose depends on what you’re eligible for and how you want your debts handled.
The most common types of bankruptcy are Chapter 7 and Chapter 13. This article breaks down these two options, including how they work, the pros and cons of each and how to file.
Understanding the two most common types of bankruptcy
Before deciding which chapter of bankruptcy will work best for your situation, consider if filing for bankruptcy is the right choice. In most cases, bankruptcy is a good option for you if:
- You are facing lawsuits from creditors
- Your monthly debt payments take up more than half of your take-home pay
- You won’t be able to pay off your debt within the next five years
Remember that filing for bankruptcy will negatively impact your credit, making it more difficult and expensive to borrow money afterward. Before filing for bankruptcy, try negotiating with your debt collectors and paying your debt first. Discuss your options with your financial advisor or attorney.
What is chapter 7 bankruptcy (liquidation bankruptcy)?
Chapter 7, or liquidation bankruptcy, is the simplest and one of the most common forms of bankruptcy. It relieves you of the legal requirements to pay most unsecured debts, such as credit card debt and medical bills.
It’s called liquidation bankruptcy because you may have to sell some of your assets to repay debts. However, after this is done, you will likely be relieved of your debts completely.
How it works
You must report your income, expenses, debts and family size to determine eligibility.
Once you file for Chapter 7 bankruptcy, the court will issue an automatic stay order. An automatic stay stops most creditors from continuing to collect money from debtors, including wage garnishment.
The court will assign you a trustee if you are eligible to file for Chapter 7 bankruptcy. To pay back your creditors, the court-appointed trustee can liquidate any of your non-exempt property or assets that can be sold to pay for your debt. Exempt property that the trustee cannot sell varies by state.
Common examples of exempt property include:
- Clothing and other everyday items
- Furniture
- Appliances
- Certain tools necessary for your business
- Prescribed medical devices
After the trustee has liquidated your non-exempt property, the court will eliminate your eligible debts. Examples of debts eligible for discharge include:
- Credit card balances
- Utility bills
- Medical bills
- Unsecured personal loans
- Past due rent
Once you are out of non-exempt assets, the court will discharge your remaining debt, and creditors will be unable to collect anything else. The court cannot cancel debts deemed non-dischargeable under Chapter 7 backed by collateral. Not paying off these debts will allow your creditors to repossess property listed as collateral in the agreement.
Pros and cons of Chapter 7 bankruptcy
Chapter 7 is one of the quickest ways to resolve your debt problems, but there are definite benefits and drawbacks. If you have a limited income, unsecured debts or mostly exempt property, Chapter 7 is your best option. If one of those situations applies to you, you may be completely relieved of your debts without losing too many of your assets.
On the other hand, filing for Chapter 7 bankruptcy only eliminates eligible debts. Debts related to child support or alimony, student loans, fraud, willful injury or wrongful death are non-dischargeable. Also, if you are paying off an auto loan or a mortgage, you must continue paying those off.
Additionally, because Chapter 7 allows for the seizure of assets, creditors can repossess your car or home after the bankruptcy filing is complete if you do not make the appropriate payments. You will also need to put a lot of work into improving your credit score after filing for Chapter 7 bankruptcy.
How to file for Chapter 7 bankruptcy
Before you file, you must determine if you are eligible for Chapter 7. You need to pass a means test, which involves calculating whether you have enough income to pay off your creditors.
You can determine if you pass the means test by calculating your gross income six months before filing for bankruptcy, doubling that amount and then comparing it to the average gross income in your state. You pass the means test if your gross income is less than the state’s average. If you don’t pass and have enough funds to pay back a significant amount of debt to your creditors, you may not be eligible for Chapter 7 bankruptcy.
Once you’ve passed the means test, you must attend credit counseling from a qualified non-profit agency before filing for bankruptcy.
You can decide if you want to hire an attorney or represent yourself. With or without an attorney, you must complete all necessary forms — called a bankruptcy petition — and submit them to the court.
Once you have filled out and filed the petition, a court-appointed trustee will take over the process. They will arrange a meeting with you and your creditors and review your paperwork to ensure you are eligible for Chapter 7.
What is chapter 13 bankruptcy (wage earner’s plan)?
Chapter 13 — also called a wage earner’s plan — is usually for individuals who earn a regular monthly income. You can keep your assets by filing for Chapter 13 bankruptcy, but you will need to develop a reorganization plan to pay off your debts over three to five years.
How it works
Chapter 13 bankruptcy requires you to pay off all of your debts. Once you’ve filed for Chapter 13, an automatic stay will stop debts or foreclosures for three to five years. You must create and submit a repayment plan to the court showing how you will repay your debts. Preparing a repayment plan can be very complicated, so hiring an attorney to assist is a good idea.
You may ask the court to forgive part of the debt or lower interest rates. Once the court approves the plan and terms, it’s final, and the creditors must accept it. When you have made the final payment of this court-approved plan, all of your debts will be discharged.
Pros and cons of Chapter 13 bankruptcy
Chapter 13 bankruptcy is best if you have a regular income and want to keep all of your property. Filing for Chapter 13 will allow you to get caught up on secured debts and resolve your other debts over three to five years. During that period, you won’t have to worry about creditors collecting your debts or pursuing legal action.
While the three to five-year window to pay off your debts is a plus, it comes with a high failure rate. The repayment plan usually takes a lot of work to pay off. Most of your disposable income will go toward paying off your debts. During the repayment period, you may also encounter financial challenges that might derail your repayments. If you cannot follow the court-approved plan, the court may convert your case to Chapter 7 bankruptcy.
Removing items like collections, charge-offs, foreclosures and bankruptcies from your credit report is challenging. It’s important to consider if filing for Chapter 13 bankruptcy is essential — like Chapter 7, it will negatively affect your credit score for a long time.
How to file for Chapter 13 bankruptcy
The process of filing for Chapter 13 bankruptcy is similar to filing for Chapter 7, though it’s more complicated. Like Chapter 7, you need to attend credit counseling. You must draft a repayment plan; a counselor may help you create it.
After you hire an attorney and fill out all the necessary paperwork, you can file for bankruptcy. The court will appoint a trustee, and an automatic stay will stop any collection of your debts. You must submit your repayment plan within two weeks of filing for Chapter 13. You need to start making payments according to that plan within 30 days.
The trustee will hold a meeting between you and your creditors to discuss the issues. After you’ve agreed to the repayment plan terms, you will attend a confirmation hearing where the court will confirm the repayment plan.
Key differences between Chapter 7 and Chapter 13
While both Chapter 7 and Chapter 13 will help resolve your debts, there are critical differences between the two.
Who’s allowed to file
Chapters 7 and 13 are the best options for individuals overwhelmed with debt. To be eligible to file for Chapter 7 bankruptcy, you must first take a means test to determine if your gross income is lower than your state’s average. High earners will generally be unable to apply for Chapter 7 and must file for Chapter 13 bankruptcy.
Eligibility requirements
If you pass the means test, you can usually file for Chapter 7 bankruptcy. You cannot file for Chapter 7 if you’ve had a Chapter 7 discharge in the previous eight years or a Chapter 13 discharge in the last six years.
You can file for Chapter 13 bankruptcy if you do not pass the means test. Chapter 13 is limited to individuals who earn an income and are current on their taxes. If you have filed a Chapter 13 bankruptcy in the previous two years or a Chapter 7 bankruptcy in the last four years, you will not be eligible to file for Chapter 13. You also cannot have secured and unsecured debts that combine for over $2,750,000 on the day of filing.
In both cases, if you filed for Chapter 7 or 13 bankruptcy in the past 180 days and the court dismissed it because you failed to appear in court or did not comply with court orders, you will not be eligible.
What happens to debts
Chapters 7 and 13 handle debts differently. Chapter 7 allows you to discharge your debts by selling non-exempt assets, whereas Chapter 13 discharges debts by creating a repayment plan and paying the debts off over three to five years. Filing for Chapter 7 and discharging your debts will usually take less than six months. For Chapter 13, your debts will be discharged after you complete your repayment plan.
It is a challenge to remove bankruptcy from your credit report. Both forms of bankruptcy will have negative consequences for your credit score. A Chapter 7 bankruptcy filing will remain on your credit report for up to 10 years, while a Chapter 13 filing will remain on your credit report for seven years after you complete the repayment plan.
It can take a long time to repair bad credit, but lenders often view a Chapter 13 filing as better than a Chapter 7 filing because Chapter 13 bankruptcy requires you to make regular payments for several years.
What happens to properties
When you file for Chapter 7 bankruptcy, a trustee will liquidate your non-exempt property until you meet your debt obligations or run out of non-exempt property. At this time, the court will discharge your debts, and you can hold on to all your assets deemed exempt. Any secured debts may still require payments. Failing to pay off these debts on your own could result in the repossession of your property.
With a Chapter 13 bankruptcy filing, you can keep your assets as long as you can pay off the court-approved repayment plan.
Should you hire a bankruptcy attorney?
When dealing with bankruptcy law, it’s generally a good idea to consult an attorney. Not all filers hire a bankruptcy attorney, but there are risks with representing yourself. The court may throw out your case due to filing mistakes, or some debts may not get discharged.
Deciding which chapter suits your situation best
Choosing between Chapter 7 and Chapter 13 bankruptcy depends on your financial situation and how you want to resolve your debts. Chapter 7 is fast and allows you to settle your eligible debts. Filing for Chapter 13 bankruptcy will allow you to hold on to your assets and pay off all your debts over several years.
If you decide to file for bankruptcy, it may take a long time to repair your credit. You should consult with a bankruptcy attorney to ensure you make the best decision.