Bankruptcy Chapter 7 vs. Chapter 13
You’ve probably heard people refer to different “chapters” of bankruptcy. Contrary to what it sounds like, this has nothing to do with a good book! In this case, the word “chapter” refers to the type of bankruptcy filed. Most consumers file either a Chapter 7 or Chapter 13. Let’s talk about the differences.
Chapter 7 Bankruptcy: Liquidation
The basic idea with a Chapter 7 bankruptcy is that your assets are sold to pay your creditors. You are assigned a trustee, who evaluates your property to see if there is anything valuable enough to be sold. Some property is considered “exempt” from the creditor’s reach, while other property is “non-exempt,” meaning that it can be sold to repay creditors.
People often assume that exempt items are simply things that are important, like a house or a car. Contrary to popular belief, it’s not always that cut and dry; exemptions are actually dollar amounts. If your assets are worth more than the exemption dollar amount, the item can be sold, and the court will give you the cash value of the exempted amount. For example, if you have $2,000 in home equity, and the federal exemption laws allow you to have $21,625, your house would be exempt from the creditors. However, if your house has $50,000 in equity, only $21,625 would be considered exempt. Thus, the house would be sold and you would be allowed to keep $21,625, while $28,375 would go to your creditors. Exemption laws are guided by the state in which you reside.
If you file a Chapter 7 bankruptcy and have no assets of large value, everything is exempt. This is called a “No Asset Case,” and the courts will not sell your property. If you have secured property that you wish to keep, like a house or car, you will still need to make payments on that debt moving forward if you wish to keep it. An experienced bankruptcy attorney can help guide you through the exemption process.
Chapter 13 Bankruptcy: Reorganization
A Chapter 13 bankruptcy also involves repaying creditors. But, instead of selling valuable assets, you use income earned on your job to repay creditors through a repayment plan. Similar to the Chapter 7, there is also a trustee involved. A trustee in a Chapter 13 collects your monthly payment and disburses that money to your creditors.
A Chapter 13 bankruptcy separates your unsecured debt and arrears from your secured debt, and gives you 3 to 5 years to repay the debt. This can be a great resource for someone with mortgage arrears. Typically, a mortgage company might only give a borrower a few months to catch up on past due payments. A bankruptcy would spread those payments over 36-60 months, making the mortgage payments a lot more affordable.
In addition to allowing a longer repayment period for arrears, Chapter 13 repayment plans also allow the debtor to pay less to unsecured creditors. Many people end up paying somewhere between 5 to 80 percent of the total unsecured debt owed. For example, if you owe $10,000 and the courts decide that you only need to pay 40 percent of your debt, you could pay $4,000 and the remaining debt would be wiped away.
As previously mentioned, a Chapter 13 bankruptcy uses employment wages. In order to discharge your debts, you would need to make payments into the plan for the duration of the bankruptcy. If anything changes in your financial situation where you can’t make payments, it is imperative that you speak with the bankruptcy trustee about adjusting your plan payments.
Keep in mind that with both a Chapter 7 and Chapter bankruptcy, you get the benefit of the “automatic stay.” The moment a bankruptcy is fled, an automatic stay stops your creditors from taking legal action against you. That means that any creditors pursuing foreclosure, repossession, wage garnishment or collections would have to stop in their tracks. Some debtors facing home foreclosure file for a Chapter 13 bankruptcy, and then use the extended repayment period to stay in the home and get their finances back on track.
Bankruptcy Means Test
Now that you understand the differences between Chapter 7 and Chapter 13 bankruptcy, you may be wondering who decides which chapter a debtor files. You can't pick the one you prefer. There is an aspect of the bankruptcy law called the Means Test, which dictates the chapter of bankruptcy the debtor files. This can be a complicated area of the law, so it is always wise to get the help of an experienced bankruptcy attorney.
Disclaimer: This article is not to be used for legal advice. Speak with an attorney if you have specific questions about bankruptcy and how it would impact you.