Chapter 7 vs Chapter 13: Bankruptcy Explained

Have you ever taken on serious debt and felt like you’re in over your head, simply based on your inability to pay your bills? Whether you’ve had a gap in employment, been buried by medical bills or taken on too much consumer debt, sometimes it can seem as though there’s no way out of your plight.

If you’ve already explored other avenues of tackling your debt such as refinancing your mortgage or taking on a second job, it may seem that a bankruptcy could be your only option. And when you’re besieged by creditors and experiencing financial stress, it could indeed be a viable choice as a last resort. If you’ve determined that this is your best course of action, here’s how to proceed.

First you must decide which of the two bankruptcy chapters best applies to your situation: Chapter 7 or Chapter 13.

Known as a liquidation bankruptcy, individuals filing for Chapter 7 must sell their assets that are “secured,” such as a house or a car. Only then will the rest of their unsecured debt (e.g., credit card debt or unpaid medical expenses) be discharged and they won’t have to pay it back.

Only individuals who pass a means test (something that determines if their income is too low to allow for repayment) are eligible to file for a Chapter 7 bankruptcy.

By contrast, a Chapter 13 bankruptcy is known as a “reorganization” bankruptcy. You’ll create a repayment plan which will allow you to pay your creditors a defined amount over a set period of time (typically 3 – 5 years) rather than selling your property. Once you’ve paid off the agreed-upon portion of your debt, your other unsecured debts may also be discharged.

Not sure which one is right for you? Read on to find out more about Chapter 7 vs. Chapter 13 so you can make the decision that’s right for your individual situation.

 

Chapter 7 Vs. Chapter 13: What Happens To Your Property When You File Bankruptcy

Bankruptcy doesn’t mean automatically getting rid of all your property or life savings. There are “exemptions” dictated by both your state and the federal government. In some states you can choose to use either your specific state exemptions or the federal exemptions. Find more about what your state allows here to compare it to the federal exemptions outlined below.

Chapter 7 Bankruptcy

Even though Chapter 7 is known as a “liquidation” bankruptcy, it doesn’t mean you must immediately sell everything when you file. Your Chapter 7 bankruptcy paperwork will contain an itemized list of all your property and the “exemptions” you can claim for each item. (See below on how exemptions work.)

If the item isn’t covered by an exemption, the trustee can sell it and distribute the proceeds to your creditors. If the exemption covers the entire item, it’s yours to keep. If your item is worth more than the exemption, you’ll be paid the difference. For example, if your vehicle is worth $10,000 and the exemption is $5,000, the trustee will sell it, give you $5,000 to cover the exempting and set aside the rest for your creditors.

Below are more details on the most well-known exemptions, but note that the amounts double for married couples. If an item isn’t covered by the exemption, your trustee will sell the property and use the proceeds to pay down your unsecured debts.In some cases where there are items you’d like to keep that aren’t subject to an exemption (or you’re over your limit), the bankruptcy trustee might allow you to purchase it. However, you must show that you’re using funds that aren’t part of the bankruptcy estate such as wages earned after you filed the bankruptcy or a loan from friends or family.

On to the federal exemptions:

• Real estate:Each state has its own “homestead exemption,” but if you’re following the federal exemptions you can protect $25,150 of equity in your principal residence where you currently live. (Note that you can’t protect equity in investment or rental properties.)
• Personal property:There are also exemptions for your property. The most common ones include:
• $4,000 for your motor vehicle
• $1,700 for jewelry
• $13,400 in household items such as appliances, clothes and furnishings (with no one item worth more than $625)
• $2,375 for “tools of the trade” including tools, machinery or computer equipment
• Life insurance policy:This will end up being $13,400 in loan value, accrued dividends or interest.
• Retirement accounts:If your retirement account (such as a 401(k)) is exempt from taxation it’s fully exempt, although that tops out at $1,362,800 for IRAs and Roth IRAs.
• Wildcard exemption:This means that $1,325 plus $12,575 of any unused portion of your homestead exemption can be used to exempt a property item of your choice.

Chapter 13 Bankruptcy

In a Chapter 13 bankruptcy you’re not “liquidating” your assets. This means you get to keep your property, but some if it may come at a cost. That is, you can only exempt a certain amount of equity in some items. Each state has their own rules, however exemptions will typically cover your car and home as well as personal and household items.  

Other property such as luxury items (e.g., a boat or an extravagant collection) will be non-exempt. The trustee won’t sell these items as they would in a Chapter 7 bankruptcy. That said, you’ll have to pay for the value of non-exempt items through your repayment plan in order to reimburse your unsecured creditors. Depending on their income and the value of their non-exempt assets this could be unsustainable for some people. Therefore, selling them would be their best option.

For your unsecured debt (such as what’s owed to credit card companies) the amount you owe will be determined by your disposable income. This is calculated by a means test. As discussed earlier, a means test will indicate how much bankruptcy relief you’ll receive.

For your secured assets (such as your home and car) you’ll continue to make payments, but you’ll also put the property up as collateral which means that your creditor could take it back if you don’t make the agreed-upon payments. Chapter 13 allows a 3 to 5-year repayment plan to catch up on past payments, meaning creditors can’t repossess your car or foreclose on your home in the meantime.

Chapter 7 Vs. Chapter 13: Eligibility For Bankruptcy

Not just anyone can file for bankruptcy, and that’s good since it truly should be a last resort.

In general terms, Chapter 7 bankruptcy will depend on your disposable income in relation to your income as opposed to Chapter 13 which looks at the total amount of your debt. 

Chapter 7 Bankruptcy

Chapter 7 bankruptcy is designed for someone who doesn’t have sufficient disposable income to repay creditors without having the debts forgiven. The higher your disposable income, the less likely you can file for Chapter 7. And it’s not based on your personal opinion of the value of your disposable income; your candidacy will be decided based on the results of these forms: the statement of your monthly income (whether it’s below the median for your state) and the means test calculation.

Chapter 13 Bankruptcy

For Chapter 13 bankruptcy you must prove you have regular income, and you can’t have more than $419,275 in unsecured debt or $1,257,850 in secured debt. Note that these amounts are adjusted every 3 years for inflation. These numbers are as of April 2019; the amounts for cases filed prior to that was $394,725and $1,184,200respectively. The next adjustment will be in April 2022.

How To Apply For Chapter 7 Or Chapter 13 Bankruptcy

Let’s take a look at the filing process for Chapter 7 versus Chapter 13 bankruptcy. (All the forms you might need can be found here.)

Here are the basic steps for filing for a Chapter 7 bankruptcy:

1. Complete mandatory credit counseling within 180 days of filing. Here’s a list of approved agencies.
2. Complete the paperwork that shows you passed the “means test” eligibility requirement.
3. File a petition with your local bankruptcy court. Confirm what paperwork you need to bring such as proof of income and expenses, tax returns, property exemptions and more. This will start the process and yield an “automatic stay” which means creditors may no longer try to collect.
4. Meet with your bankruptcy trustee and creditors. You’ll answer questions about your finances and the information you filled out on the forms.
5. Receive your “eligibility.” The trustee and court can now make a decision on whether you can proceed. If they decide against your candidacy you still have the option to file a Chapter 13 bankruptcy.
6. Find out about your property. This is when the trustee will decide how to handle your non-exempt property as well as your secured debts.
7. Complete a financial management course. Find an approved agency, complete the course and submit the form thereby certifying completion, all as directed by your bankruptcy trustee.
8. Receive your discharge.

And here are the steps to file for a Chapter 13 bankruptcy:

1. Complete mandatory credit counseling within 180 days of filing. Here’s a list of approved agencies.
2. Complete the paperwork to file for Chapter 13 bankruptcy. This will include:
   • Creditors and amounts owed
   • Income verification
   • Tax return
   • An itemized list of your monthly living expenses
   • List of property and all accounts and leases
3. File a petition with your local bankruptcy court. As with Chapter 7 this will yield an automatic stay.
4. Create a repayment plan and submit within 14 days of filing your petition.
5. Start following the plan within 30 days after filing your papers even if it’s not yet approved.
6. Meet with your bankruptcy trustee and creditors. You’ll answer questions about your finances and proposed plan.
7. Attend a confirmation hearing where the judge will rule on whether to approve the plan. You may have to modify the plan if it’s not approved.
8. Follow the plan for the next 3 – 5 years, working with your trustee who will collect and distribute the payments.
9. Complete a financial management course with an approved agency.
10. Receive your discharge after all requirements have been met.

Can Creditors Still Contact You After You File?

The good news is that those upsetting calls will come to an end when you file for either of these bankruptcy chapters. That’s because an automatic stay goes into effect immediately after filing which prevents collection agents from contacting debtors. While that includes garnishment of wages it doesn’t halt criminal cases, some child support actions and certain eviction situations, nor does it apply to any debts you incur after you’ve filed.

If a creditor contacts you, first inform them of the bankruptcy as they’re is likely unaware.

If the harassment continues, notify the bankruptcy court which will determine the next action (something that might include fines or fees).

Chapter 7 Vs. Chapter 13: Which Should You File?

Your first step should be contacting a professional to help you determine whether Chapter 7 or Chapter 13 is right for you. And of course, you must refer to the limits above to see if Chapter 7 is even a possibility. Otherwise, read below for some more considerations that might indicate whether Chapter 7 or Chapter 13 is better for your situation.

Chapter 7 might be appropriate if:

• It would take 5 or more years to pay off your debt even if you took all available measures.
• You have limited assets.
• Your problem debts total more than 40% of your annual income so it’s unlikely you’ll be able to repay your creditors.

Chapter 13 might be the right choice if:

• You’re behind on your mortgage or car loan but would prefer to get current on payments rather than lose your property.
• You feel you’d be able to be current on your debts if you had more time.
• You have non-exempt property (such as an heirloom collection or specialized sporting equipment) that you’d like to keep even at a cost.

What You Should Do After Filing Bankruptcy

In addition to following all court orders and plans that have been approved, you’ll want to get to work rebuilding your credit. Your credit report won’t look clean for a while; a Chapter 7 bankruptcy stays on your report for 10 years and a Chapter 13 slides off after 7 years.

And while it’s true that lenders might cast a wary eye on extending credit to someone with a bankruptcy on their credit report, you can still start implementing better financial wellness habits right away. Some places to begin are:

• Reviewing your credit report: Make sure all the accounts show that they’ve been discharged or are listed as “included in bankruptcy” rather than as “delinquent” or “outstanding” so creditors don’t continue to harass you.
• Applying for an entry-level credit card: A card with a low limit is a good way to get back on your feet credit-wise.
• Reinforcing smart financial habits: Ideally your credit counseling classes offered smart strategies for responsible financial management, such as budgeting. One of the most important things you can do for solid credit is to pay your bills on time, every time. Create new habits and you’ll be well on your way to rebuilding your financial life with your bankruptcy behind you.

The good news is that while bankruptcy is a huge misstep, it doesn’t have to dictate the rest of your future. Financial health is around the corner if you start exercising wise habits and moving forward with a clean slate.

As with any major financial decision, it’s best to consult a financial advisor to determine what’s right for you and your situation.

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