Chapter 7 Vs. Chapter 13 – Forbes Advisor

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Choosing to file for bankruptcy is a big decision, but it’s the first of many that filers will encounter as they go through the process. One of the most important decisions you’ll make is the type of bankruptcy to file. Generally, individuals may file either a Chapter 7 liquidation bankruptcy or a Chapter 13 reorganization bankruptcy, but the one that’s best for you depends on your needs and situation. It’s wise to learn about both types of bankruptcy before making any decisions.

Bankruptcy Basics

The Bankruptcy Code, which governs all US bankruptcies, specifies six bankruptcy types, each named after a chapter of the code. They are similar in that all can protect overburdened debtors from creditors, allowing debtors to avoid repaying some or all debts. They differ in that they are each intended for certain classes of debtors, and each bankruptcy type has a different process.

Individuals typically file under Chapter 7 or 13 since these types of bankruptcy are geared more toward individual debtors. Chapter 11, although primarily employed by businesses, may be appropriate for sole proprietors and some other individuals in business. Municipalities may file under Chapter 9 to reorganize debt and Chapter 12 is a type of bankruptcy for family farmers and fishermen. Chapter 15 bankruptcy is used when filings involve parties from multiple countries.

Chapter 7 Bankruptcy

The defining trait of Chapter 7 is that the filer’s assets get liquidated, which is why it’s also known as liquidation bankruptcy. Any nonexempt property is turned over to a trustee, who sells the assets and distributes the proceeds to creditors. At the end of the liquidation and distribution process, the filer doesn’t owe the creditors.

Some assets are exempt from liquidation. The list of exempt assets varies by state but typically includes personal clothing, furnishings and, up to a particular dollar value, an automobile. In practice, most Chapter 7 filers have only exempt assets, so nothing gets liquidated. In these so-called no-asset cases, creditors get no repayment.

With or without repayment to creditors, an individual’s debts still are eliminated or, in bankruptcy jargon, discharged. The debtor no longer owes these debts, and creditors must stop trying to collect. Chapter 7 generally automatically discharges eligible debts. However, only some debts are eligible. Non-dischargeable debts usually include most tax debts, student loans, child support and alimony debts.

Also, while Chapter 7 may clear you of the responsibility to pay a secured debt, such as your mortgage or auto loan, you generally won’t be able to keep the property unless you pay off the lien.

Eligibility Requirements

In Chapter 7, debtors have to pass what’s referred to as a Means Test. To pass, the filer must not have a household income higher than the median income in their state. Otherwise, the bankruptcy court may instruct the debtor to file under another chapter, usually Chapter 13.

Chapter 7 filings have other requirements as well. For instance, debtors must complete a credit counseling course from an approved provider as part of the process. Without it, the discharges won’t be granted.

While Chapter 7 usually wipes out all dischargeable debts, some filers may volunteer to pay off one or more debts, a process called reaffirmation. With reaffirmation, the debtor agrees to pay all or a portion of the amount owed, and the creditor agrees not to repossess or take back the property so long as the debtor continues to pay. For instance, a debtor may want to avoid having an auto seized for nonpayment. The debtor can keep making payments and hang onto the car by reaffirming the debt.

Chapter 7 is the simplest kind of bankruptcy and some debtors choose to represent themselves without an attorney, known as going pro se. However, because of bankruptcy’s long-term financial and legal consequences, hiring an attorney is strongly recommended before filing for bankruptcy.

Chapter 13 Bankruptcy

Chapter 13, also called a wage earner’s plan, is generally for individuals with a regular income from a job. This chapter allows files to keep valuable assets, like a home, and develop a plan to pay off debts over time. Chapter 13 also provides a discharge of certain types of debt, including those from and some tax obligations.

The downside of Chapter 13 is that the debtor has to pay back some or all of the debt. As part of the process, the filer must submit and get the court to approve a plan to repay debts over three to five years. Debts get discharged only after the last payment is made.

As part of the repayment plan, the debtor can ask for lower interest rates and even get part of the balance forgiven. Creditors can object to the plan but, once approved, creditors have to accept it.

Eligibility Requirements

Just as the Means Test limits who can file under Chapter 7, a debt cap restricts availability of Chapter 13. Only debtors with unsecureds less than $394,725 and secured debts less than $1,184,200 are eligible to file under Chapter 13. The amounts are adjusted periodically for inflation.

Because of the complexity of preparing a repayment plan, Chapter 13 filers are generally more likely to hire attorneys to help with the process. This increases the chances of a successful filing, but attorney fees will often be higher than with a Chapter 7 case.

Summary of Chapter 7 vs. Chapter 13

Here’s a summary comparing major traits of these two chapters:

Which Chapter Is Right for You?

Much depends on individual circumstances, but—for some broad classes of debts—one chapter is more likely to be better than another:

  • Chapter 7. This is usually best for filers with limited income and only unsecured debts, such as credit cards and personal loans. Chapter 7 is also a better choice for a filer who wants to get the process over with fast, and who may not have the money to hire an attorney.
  • Chapter 13. This is likely to be the smartest type of bankruptcy for a filer who has regular, reliable income, wishes to keep some of their assets and can pay debts over time. Chapter 13 filers have to be ready to fulfill the repayment plan, which may take three to five years, and will generally need the money to pay an attorney.

Credit Consequences of Chapter 7 vs. Chapter 13

Declaring bankruptcy, in general, has a negative impact on your credit, whether you file Chapter 7, Chapter 13 or another type of bankruptcy. Filing bankruptcy can make it more difficult and more expensive to borrow money in the future.

A Chapter 7 filing stays on your credit report for up to 10 years, while Chapter 13 may remain on your report for up to seven years. Notably, the seven-year period in Chapter 13 only starts after the repayment plan is completed, which, as mentioned above, generally takes three to five years.

Lenders may see a Chapter 13 filing as less negative than a Chapter 7 filing. This is because a filer who completes a Chapter 13 bankruptcy has made payments reliably for several years and has ultimately paid off all, or most, of their debts. This can reassure a lender that the loan is likely to be repaid.

In either case, there is much you can do to rebuild credit after bankruptcy. By using secured credit cards, co-signers and making on-time payments, people who have filed for bankruptcy may regain their former credit standing.

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Bottom Line

One trait all bankruptcies filed under any chapter share is a certain amount of stigma. Bankruptcy is, appropriately, regarded as a last resort. But it’s not the end. There’s a long list of well-known people who have sought bankruptcy protection and gone on to achieve success, including former President Abraham Lincoln, musician Cyndi Lauper, and entrepreneur and former boxer George Foreman.

Bankruptcy need not be a defining financial act. By freeing filers from unsustainable debt, bankruptcy offers a way to build a new and more prosperous future.

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