Understanding personal bankruptcy: Chapter 7 vs. Chapter 13
There are two primary types of personal bankruptcy
- Chapter 7 bankruptcy discharges all of your unsecured debt, but you often lose your property
- Low-income or unemployed individuals with few assets to liquidate may benefit from Chapter 7
- Chapter 13 bankruptcy entails a court-approved plan to repay a portion of your debt and discharge the remainder
- Employed individuals who want to protect their property may benefit from Chapter 13
Individuals shouldering a millstone of debt with no feasible way to repay it can file for bankruptcy to wipe the slate clean. The two types of personal bankruptcy filings — Chapter 7 and Chapter 13 — have different eligibility requirements and affect your debt in different ways. The option that makes sense for you depends on your debt, income and assets.
Two types of personal bankruptcy
Chapter 7 bankruptcy is known as liquidation or complete bankruptcy, and discharges all of your unsecured debt. Many of your assets, potentially including your house or car, are liquidated to pay your creditors. To be eligible for Chapter 7 bankruptcy, you must pass a means test to prove that your income is no more than the state median for your family size. You cannot have any co-signers on your loans, either — co-signers would be expected to repay the debt if you are unable.
Chapter 13 bankruptcy is known as reorganization or wage earner’s bankruptcy, and allows you to keep your assets while repaying some or all of your debt through a court-approved plan. To qualify for Chapter 13 bankruptcy, you must have sufficient disposable income to meet repayment obligations. As of 2018 limits, your total secured and unsecured debt cannot exceed $1,184,200 and $394,725, respectively.
There are two other forms of bankruptcy that apply in special situations: Chapter 11, which is typically only for businesses owners, and Chapter 12 for farmers and fishermen.
Before you file
Filing for bankruptcy is not a decision to take lightly. Bankruptcy significantly harms your credit score and remains on your credit report for several years — seven years for a Chapter 13 bankruptcy and 10 years for a Chapter 7. This impacts your ability to access future financing. Potential employers may also pull your credit and see the bankruptcy.
For most individuals, bankruptcy should be used as a last resort after exhausting all other means of getting a handle on your debt, such as debt consolidation or exploring loan modification with your lenders. Note that certain debt — including but not limited to child support and alimony, back taxes and federal student loans — cannot be discharged in any form of bankruptcy.
Bankruptcy costs money as well. Although filing fees are typically no more than $400, many people hire an attorney to help them navigate the process and onslaught of paperwork. Legal fees often total several thousand dollars.
To be eligible to file for Chapter 7 or Chapter 13 bankruptcy, you are required by law to complete a federally approved credit counseling course educating you on the alternatives to — and long-term implications of — bankruptcy. After filing for either Chapter 7 or Chapter 13 bankruptcy, you must also complete a personal finance management course before your debts are discharged.
Chapter 7 bankruptcy
In a Chapter 7 bankruptcy, a court trustee takes over your financial accounts and can liquidate almost all of your property to repay your creditors. Any remaining unsecured debt that can’t be repaid is discharged. If married and filing as an individual, your spouse’s assets are typically not considered part of the bankruptcy estate, unless you live in a so-called “community property state,” where married couples share all debts and assets.
You may be able to keep certain property such as a home or a car, depending on the state where you live and the total equity you have in that asset. States set an exemption limit for various property types, meaning you have the right to a portion of the equity you have in it but not necessarily the entire asset itself.
Consider your house, for example. Say the exemption limit for a home in your state is set at $125,000. If your home is worth $400,000 and your mortgage balance is $250,000, you have $150,000 in home equity. The trustee would likely sell your home, issue you an exemption check for $125,000 and use the remaining proceeds to pay off your creditors. Only if your house is worth less than $125,000 — or close enough to that amount that selling the home would not be worth the cost of doing so — would you be able to keep your home.
Depending on your state, you may be required to adhere to state bankruptcy exemption limits or have the choice to apply either state or federal bankruptcy exemptions. You must use one exemption code across all of your property, however.
Given the possibility of losing most of your assets, Chapter 7 bankruptcy is typically a better choice for low-income or unemployed individuals with few assets that can be liquidated. The Chapter 7 process typically takes three to six months from filing to debt discharge.
Chapter 13 bankruptcy
Chapter 13 bankruptcy often makes sense for employed individuals who want to keep property that may be liquidated in Chapter 7 and are willing to work toward repaying their debt. There is no income requirement to file Chapter 13, making it an option for those who do not pass the means test for Chapter 7 bankruptcy.
Your debt is not immediately discharged in Chapter 13 bankruptcy. Instead, you must first establish a three- to five-year plan to repay your creditors to the best of your ability. Not all of your creditors are repaid in full and the court, not your creditors, must approve your repayment plan.
After you have made payments in accordance with the term of the repayment schedule, much — if not all — of your unsecured debt is discharged.