Chapter 7 vs. Chapter 13 Bankruptcy

Chapter 7 and Chapter 13 bankruptcy are the two most commonly filed types of bankruptcy. Each is a legal tool to get debt relief if you’re no longer able to keep up with your minimum payments. Which one of these bankruptcy options is right for you depends on your financial situation and goals for the future. Even though there are many differences between Chapter 7 and Chapter 13 bankruptcy, each one grants the filer a fresh financial start in the form of a bankruptcy discharge. The discharge is a court order that permanently bans creditors from trying to collect money from you. 

After a brief overview, this article will explore the differences between Chapter 7 and Chapter 13, which type of bankruptcy is better depending on the situation, and the downsides of each. 

Chapter 7 Bankruptcy 

Chapter 7 bankruptcy filers get their discharge within 3 - 4 months after their bankruptcy petition is filed with the United States bankruptcy court. Creditors are not allowed to contact you once your case is filed. Although bankruptcy law says you have to sell certain property to pay your unsecured creditors, if you’re like most Americans, you’ll be able to keep all of your belongings. That’s because bankruptcy exemptions limit what type of property can be used to pay creditors. There’s no limit to how much debt you can have in a Chapter 7, but you can’t make too much money. That’s one of the main differences between Chapter 7 and Chapter 13 bankruptcy. 

Chapter 13 Bankruptcy

Chapter 13 bankruptcy involves a repayment plan. Although creditors can object to how much they get under the Chapter 13 plan, once the bankruptcy court approves it, they are bound by it. The monthly payment is based on what you can afford to pay. Unlike in Chapter 7, you can reduce the interest rate and, in some cases even the balance owed, on your car loan by filing Chapter 13. Since creditors receive some money in a Chapter 13 bankruptcy, filers are not required to give up any non-exempt property. Debt that is not repaid is eliminated by a Chapter 13 bankruptcy discharge after the 3 - 5 year repayment plan is done. 

When Chapter 7 Is Better Than Chapter 13

Knowing the basic differences between Chapter 7 and Chapter 13 bankruptcy is a start, but it’s hardly enough to help you decide which type of bankruptcy is for you. Let’s start by taking a look at when Chapter 7 bankruptcy is better than Chapter 13. 

Chapter 7 is better if...

• you only have unsecured debt, like credit card debt, medical bills, balances owed after a repossession, personal loans,  etc., 

• you don’t have a regular income or not enough income to cover your living expenses like housing and food, 

• you can’t afford to hire a bankruptcy lawyer to help you with your bankruptcy case, 

• you don’t have any non-dischargeable debts like alimony or child support or you’re current with your payments on these obligation,

• you’re not able to commit to a repayment plan for at least the next 3 years. 

When Chapter 13 Is Better Than Chapter 7

If you have some disposable income and don’t have too much debt, you have the option to choose between Chapter 7 and Chapter 13 bankruptcy. 

Chapter 13 is better if…

• you want to keep property that’s not protected by an exemption, 

• you’re behind on your mortgage and want to catch up, 

• you have debts that can’t be discharged, 

• you have a car loan with a high interest rate or negative equity from a trade-in

• you have multiple mortgages

• you owe money to your ex-spouse from a property settlement 

Of course, life isn’t always that clear cut, so it’s also important to consider the downsides when weighing your bankruptcy options. 

The Downsides of Chapter 7 Bankruptcy

Since Chapter 7 bankruptcy is by far the most common - and often preferred - type of bankruptcy, let’s start with a look at some of its downsides. 

The bankruptcy trustee can sell any property not protected by an exemption

Bankruptcy exemptions protect most “basic” property - things like clothing, furniture, retirement accounts, and - at least up to a certain amount - cars. The state you’re filing bankruptcy in determines the type of bankruptcy exemptions you’re able to use. That's because the Bankruptcy Code gives each state the option to require their residents to use state law instead of bankruptcy law to protect their belongings. If you own non-exempt property and don’t want it to be used to pay at least a portion of your debts, a Chapter 7 “liquidation bankruptcy” may not be right for you. Chapter 13 allows you to keep nonexempt property. 

It doesn’t help with expensive car loans if you want to keep the car

Even though bankruptcy law allows you to keep your not-yet-paid-off car even after filing a Chapter 7 bankruptcy, you’ll likely be stuck with the same car loan. After signing a reaffirmation agreement, most Chapter 7 filers are stuck with the same high interest rate on their loan and often owe much more on it than the car is worth. This can seriously lessen the positive impact your fresh start will have on your monthly budget. 

It doesn’t help with non-dischargeable debt or past due mortgage obligations

Much like a car loan, if you owe non-dischargeable debt, like tax debt, filing Chapter 7 will not change much. A Chapter 13, on the other hand, can be used to pay off non-dischargeable priority debt so when your discharge is entered, you’re truly debt free. 

If you own a home but have fallen behind on your mortgage payments, Chapter 7 bankruptcy won’t help you catch up. In a Chapter 13 bankruptcy you have up to 5 years to bring your home loan current. 

Chapter 7 bankruptcy stays on your credit report longer than Chapter 13

Although you can start rebuilding your credit score as soon as your discharge is entered, the fact that you filed Chapter 7 bankruptcy will stay on your credit report for 10 years. Chapter 13 is typically removed from your credit history 7 years after the date the bankruptcy case was filed.

Finally, if you make too much money, you may not qualify to file Chapter 7 bankruptcy

If you have disposable income greater than the limit set by the means test, you may not be eligible to file bankruptcy under Chapter 7. While that may be less of a downside and more of a limitation on your bankruptcy options, it’s important to understand how this part of the Bankruptcy Code affects you. 

If your household income exceeds your state’s median income, bankruptcy law requires you to show that you don’t have the disposable income necessary to commit to a Chapter 13 repayment plan. If you don’t pass the means test, you’re not able to file bankruptcy under Chapter 7 of the Bankruptcy Code. 

The Downsides of Chapter 13 bankruptcy

Even though Chapter 13 may be better for your specific financial situation, if you pass the means test and truly have a choice between the two types of bankruptcy, make sure to consider the downsides to Chapter 13 bankruptcy. 

It’s a 3 - 5 year commitment 

A Chapter 13 repayment plan has to be at least 3 years long. That means you’ll have to make at least 36 monthly payments to the bankruptcy trustee. A lot can happen in 3 years and you’ll only get your discharge if you successfully complete your repayment plan. 

The bankruptcy trustee will monitor your income 

You’ll have to send a copy of your income tax return to the Chapter 13 bankruptcy trustee every year during your bankruptcy case. What’s more, if you get a tax refund, you may have to pay that refund to your unsecured creditors in addition to your regular monthly plan payments. 

You really need to hire a bankruptcy attorney and that can be expensive

Even though you don’t have to hire a bankruptcy lawyer, almost all Chapter 13 bankruptcy cases filed “pro se” (without a lawyer) fail. The Bankruptcy Code’s requirements for the repayment plan and the entire Chapter 13 process are virtually impossible to get right by yourself. The average Chapter 13 bankruptcy will cost about $3,000 in attorney fees. 

It has a high failure rate

Even when a bankruptcy attorney is helping, its downsides mean that many Chapter 13 bankruptcy cases fail. Whether it’s an unexpected layoff, illness, divorce, or something else, sticking to a Chapter 13 budget can ultimately prove impossible. 

Chapter 7 vs. Chapter 13 - Let’s Summarize

When deciding between Chapter 7 vs. Chapter 13 bankruptcy, it’s important to consider: 

• the types of debt you have (unsecured v. secured debt, dischargeable debt v. nondischargeable debt), 

• if any of your personal property would be considered a nonexempt asset, 

• if your regular monthly income is enough to cover your living expenses, and

• the difference between Chapter 7 and Chapter 13 on your credit report

Conclusion

Bankruptcy can be a powerful poverty fighting tool and help thousands of families get back on their feet every month. If you’re facing wage garnishment, know the Bankruptcy Code’s “automatic stay” protects you from any future garnishment as soon as your case is filed. If you’re not sure whether bankruptcy is right for you, keep doing what you’re doing and research. You may even consider signing up for a free credit counseling session to learn more. 

Don’t be discouraged - or embarrassed - by the idea of filing bankruptcy. If COVID-19 and its impact on everyone in the United States and around the world has shown us anything, it's that life happens. Bankruptcy laws exist to give you a fresh start. There’s no shame in using this legal tool, just like Walt Disney, Abraham Lincoln, and Henry Ford did when they needed help.

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