Chapter 7 or Chapter 13: What's Best for You?
Bankruptcy is a legitimate legal process that allows people or businesses in financial trouble to erase or repay most debts and start over. It can help prevent creditors from harassing you, garnishing your wages or foreclosing on your home. But there can be a lot of shame and stress connected with filing for bankruptcy, and you may fear that it will ruin your credit forever.
"It's one of the hardest things people can do," says Ed Boltz, a Raleigh NC-based bankruptcy attorney and president of the National Association of Consumer Bankruptcy Attorneys (NACBA). "But if you file sooner rather than later, it's better for your credit in the long run." He adds that people who wait until they are facing lawsuits to file for bankruptcy often have an especially difficult time getting their finances back on track.
This guide looks at the two most common bankruptcy plans for individuals, known as Chapter 7 and Chapter 13. Both can halt debt collection and give you a new financial start. We'll explore the basics of each option and offer some insider tips. To choose the option that's better for you, you'll need to talk with a bankruptcy attorney, since our guide is not a substitute for legal advice.
Chapter 7 Bankruptcy
Chapter 7 involves liquidating your assets to eliminate debt - that is, selling the assets you have. This kind of bankruptcy eliminates unsecured debts, such as medical bills, credit cards, store cards, utility bills, payday loans and other debt that are not backed by property (collateral). It is called "liquidation" because all or some of your property may be sold (liquidated) to pay off some of your debt.
It is usually used when:
- You don't own a house or have a lot of possessions, except for basics like clothing and furniture;
- After you pay your rent and basic monthly expenses, you don't have enough left to pay down your debts
- You owe mostly unsecured debt - that is, debt that isn't tied to collateral such as your house or car. These debts may include medical bills and credit card and store card bills.
Who qualifies for a Chapter 7 bankruptcy?
- Your income is equal to or less than the median income for a family of your size in your state.
- Even if your income is higher than that, you can qualify by passing a "means test." You can pass this test if you have a lot of expenses, such as high mortgage, car loan payments and taxes that eat up your income. The Census Bureau has a state-by-state online means list. However, the means test can become complicated, so it's best to check with an attorney.
- You are a disabled veteran whose debts were incurred during active duty.
- Your debts come primarily from the operation of a business.
- You complete required credit counseling from a government-approved organization within 180 days before you file. You also have to complete a debtor education course before your debts can be discharged. Check the list of approved debtor education providers online or at the bankruptcy clerk's office in your district.
- You have not had a Chapter 7 bankruptcy in the last eight years.
Advantages of a Chapter 7 bankruptcy
- You can wipe out most unsecured debt. This is debt for which you have not pledged collateral. It means, for example, that most credit card and medical bills will be erased.
- Depending on state laws, you may get to keep essential property such as personal possession, clothes, household furnishings and your car. Social Security payments and the tools of your trade may also be exempt.
- This bankruptcy process can be completed in four to six months and is relatively cheap, costing about $335 in filing and administrative fees (not including attorney fees), and usually requires only one trip to the courthouse.
- While this is in process, an "automatic stay" immediately stops any lawsuits and most actions by creditors, collection agencies or government agencies. It stops your creditors from harassing you, taking any actions to collect money, evicting you, garnishing your wages or foreclosing your house. (But you will need to still be able to pay for your mortgage after bankruptcy).
- You can start rebuilding and be on your way to a fresh financial start in just a few months.
Fallout from a Chapter 7 bankruptcy
- Bankruptcy can stay on your credit report for up to 10 years.
- Your credit score - a three-digit number that shows how good a credit risk you are - will be lowered by up to 150 points or more. But you can start rebuilding it almost immediately. Also, keep in mind that carrying a lot of debt will lower your credit score too, perhaps as much as bankruptcy.
- It becomes public record. You are not obligated to volunteer this information to potential employers or creditors, but they can easily find out on their own.
- If you have a co-signer on any debts, the person is not protected by your bankruptcy, and creditors can go after them for repayment.
- You may have a harder time renting a new home or taking out anything other than a subprime loan for at least several years.
Chapter 13 bankruptcy
Chapter 13 is designed to halt foreclosure on a home or other secured property. It creates a payment plan so you can pay off your debts over the next 3 to 5 years. Since you need a steady income to do this, it is sometimes called a "wage earner's plan."
It is usually used when:
- You have significant investment (equity) in your house or other property and want to avoid losing it through foreclosure.
- You have a regular income and can pay basic living expenses but can't keep up with payment on all of your debts.
- You can make a plan to pay down your debts over 3 to 5 years.
- You are not eligible to file for Chapter 7 bankruptcy.
Who qualifies for a Chapter 13 bankruptcy?
- Your unsecured debts (credit cards and medical bills, for example) total less than $394,725 and your secured debts (such as mortgages) are less than $1,184,200. You must be able to prove to the court that you can afford to meet your repayment obligations.
- You can complete required credit counseling from a government-approved organization within 180 days before you file. You also have to complete a debtor education course before your debts can be discharged. Check the list of approved debtor education providers online or at the bankruptcy clerk's office in your district.
Advantages of a Chapter 13 bankruptcy
- You can stop foreclosure and keep most of your property.
- You can get placed on an interest-free plan to repay mortgage and other debts at a reasonable rate over 3 to 5 years.
- You can make one monthly payment that will get distributed among your debtors.
- Debts that can't be discharged by Chapter 7 — such as taxes and student loans—may be included in Chapter 13 filing. (See Your Debts in Chapter 13 Bankruptcy.)
- While this is in process, an "automatic stay" immediately stops any lawsuits and most actions by creditors, collection agencies or government agencies. It stops your creditors from harassing you, taking any actions to collect what you owe, evicting you, garnishing your wages or foreclosing on your home.
- You won't be contacted by your creditors over that 3- to 5-year repayment period.
- Your co-signers - such as a relative - are protected from your debts.
Fallout from a Chapter 13 bankruptcy
- Chapter 13 is more complicated and may take longer to file and be approved. The repayment plan will last from 3 to 5 years.
- Bankruptcy can stay on your credit report for up to 10 years. However, the effect of bankruptcy on your credit may be about the same as it is in your current debt situation.
- Your credit score - a three digit number that shows how good a credit risk you are - will fall by up to 150 points or more. But you can start rebuilding it almost immediately.
- The bankruptcy becomes public record. You are not obligated to volunteer this information to potential employers or creditors, but they can easily find out on their own.
- You may have a harder time renting a new home or getting anything other than a subprime loan for several years.
How to Find a Good Bankruptcy Attorney
You don't necessarily need to pay an attorney to file for bankruptcy, but it's generally a good idea.
"If your case is not complicated and you don't have a home or a lot of assets, you may be able to handle it without an attorney," says Cara O'Neil, an attorney and legal editor for Nolo Press, a publisher of legal guides for consumers.
"The problem is that there is potential for making an error, especially if you have assets you want to protect, such as your home," she says. "Once your case is filed, it stands. So if you don't completely understand the process and you make an error, you may end up forfeiting property you could have saved." If you do consult with a lawyer, it's best to find one who is well-versed in the complex laws of bankruptcy. "If you're going to see a lawyer, see a specialist. You're not going to pay any more," Boltz says. Many or most lawyers specializing in bankruptcy offer a first consult free, he added. You can find bankruptcy lawyers listed through your state's bar association, or on websites such as NACBA. Check out credentials, and don't be fooled by people who prepare forms and who say they are just as good as a lawyer. "All they are legally allowed to do is type," Boltz says. "They can't give you advice."
Filing fees are set by the courts, and are generally under $400. Costs for legal help vary. For Chapter 7, lawyers fees are generally under $2,000. For Chapter 13, they are between $3,500- $5,000. Some of the expenses may be tax deductible, so check with a tax expert.
If you can't afford a lawyer, you may qualify for free legal services. Try these resources:
The American Bar Association
The ABA may be able to connect with you with a pro bono attorney.
Legal Services Corporation
LSC is an independent nonprofit established by Congress in 1974 to provide financial support for civil legal aid to low-income Americans. The Corporation currently provides funding to 134 independent nonprofit legal aid organizations in every state, the District of Columbia, and U.S. Territories. You can find a service near you here.
You can also find more information about filing fees and attorney fees at the U.S. bankruptcy courts.
Steps for Filing a Chapter 7 or Chapter 13 Bankruptcy
ASSESS YOUR DEBT SITUATION
List your debts and your income and assets, and explore your options to see if there is a way to get out of debt without bankruptcy. Consult a non-profit credit counseling service such as Money Management International to see whether a repayment plan is feasible. This may be a difficult process, but it will help you understand your financial situation.
CONSULT A BANKRUPTCY LAWYER
If bankruptcy seems the best or only option, contact a lawyer specializing in bankruptcy to discuss your situation and how bankruptcy would work for you. Some bankruptcy attorneys offer a free first consult, or check with Legal Aid in your area.
GATHER YOUR PAPERWORK
The attorney will advise what you need to file for bankruptcy. This will include bank statements, tax returns, paycheck stubs, insurance documents and a list of debts. If you own property you will need documentation. The attorney will check debts from credit reports.
DETERMINE IF YOU ARE ELIGIBLE
Your attorney will review the requirements for Chapter 7 and see if you meet them.
ATTEND COURT MANDATED CREDIT COUNSELING
You will have to complete a credit counseling course from a government-approved organization within 180 days before you file. Check the list of approved debtor education providers online or at the bankruptcy clerk's office in your district.
FILE A PETITION WITH THE COURT
If your attorney finds you are eligible, you'll fill out a petition and a number of other forms. These will be filed with the bankruptcy court in your area. Your case and documents will be put in the hands of a "bankruptcy trustee." This trustee will have control over all over your property and debts.
GET RELIEF AS YOUR AUTOMATIC STAY TAKES EFFECT
This immediately stops any lawsuits and most actions by creditors, collection agencies or government agencies. It stops your creditors from taking any actions to collect what you owe, evict you, garnish your wages or foreclose on your house.
ATTEND A CREDITORS MEETING
Shortly after you file, a creditors meeting is scheduled at the courthouse. The trustee conducts the meeting, asking you questions about debts and the papers you filed for bankruptcy. This is usually the only courthouse meeting for a Chapter 7 bankruptcy. If you're doing a Chapter 13 bankruptcy, a repayment plan is set up and a creditors' meetings scheduled. Over the next few years, you'll report to the trustee, usually twice a year.
ATTEND A COURSE ON FINANCIAL MANAGEMENT
You will have to complete a court mandated and approved budget management education course before your debts can be discharged.
HAVE YOUR DEBTS WIPED OUT BY THE COURT (CHAPTER 7)
If all goes well, all of your unsecured debts are wiped out (discharged) within six months, except child support, alimony, most tax debts, student loans (in most cases) and debts the creditor charges were acquired through fraud. Now you can start rebuilding your credit.
GET A DISCHARGE FROM THE COURT AND BEGIN REBUILDING CREDIT (CHAPTER 13)
After you have satisfied the repayment requirements—usually 36 to 60 months after filing - the court grant a discharge. By carefully managing your income and expense and paying bills promptly, you can establish a new credit rating
So You Need to Declare Bankruptcy? Expert Advice from the Field
James Haller is president of the National Association of Consumer Bankruptcy Attorneys (NACBA). He is an attorney with the Sulaiman Law Group of Chicago and has written extensively about many aspects of bankruptcy.
Are there big differences by state in recording fees and lawyers' fees?
No. Court filing fees are set nationally. Currently, the filing fee for a Chapter 7 bankruptcy is $335 and for a Chapter 13 it's $310.
Attorney fees for Chapter 7 bankruptcies vary by region and by the complexity of the case. Most are not terribly complicated and the attorney's fees usually range from $500 to $3,000. However, a fee for a case with multiple properties, different sources of income and multiple debts can cost more than $10,000.
Chapter 13 attorney fees are usually regulated by the particular Bankruptcy Court, either hourly or by a flat fee which can vary. In some jurisdictions this fee is $5,000 and up, and in others it's $2,500. This fee is either paid before the case is filed or over the duration of the case (many times both). All fees have to be approved by the Bankruptcy Court judge.
What if you can't afford the fees?
Several districts have IFP (In Forma Pauperis) programs to waive, reduce or set up a payment plan for the Court fees. Many attorneys do pro bono bankruptcies, and many legal aid organizations have bankruptcy programs. However they're limited as to the number of clients they can handle and can only accept the most needy.
If you have a business and file for personal bankruptcy, how does that affect your business — or starting a new business?
The effect on the business depends on the assets of the business. For individuals who are sole proprietors, filing Chapter 7 can be great: it can be just like a personal bankruptcy, but eliminates even more debt. Many small business owners have their company incorporated. But they have to co-sign debt for the company in their name, so they can file Chapter 7 as an individual to eliminate that personal liability.
If you own a corporation, in Chapter 7 the Trustee liquidates the corporation and pays the creditors. Because a corporation is not a human entity, there is no discharge—that is, no wiping out of the debt by the court. So the company always has the stigma of debt and usually goes inactive.
How often can people file for bankruptcy?
An individual can file a Chapter 7 bankruptcy once every eight years, or six years after filing a Chapter 13 bankruptcy. An individual can file a Chapter 13 bankruptcy every two years, or four years after a Chapter 7. In some circumstances an individual can file a Chapter 7 and then immediately file a Chapter 13. This is colloquially called a Chapter 20, and best handled by a lawyer.
Which type of bankruptcy is most likely to save your house?
A Chapter 13 bankruptcy can save your home and potentially remove liens, depending on the circumstances. A debtor needs a steady source of income to be able to afford the payments.
A nice thing about a Chapter 13 is that it can eliminate second or third mortgages in some situations where the value of the house is less than the debts. For example: your house is worth $200,000, but you owe $250,000 on the primary (first) mortgage, and $70,000 for a second mortgage. In that situation, you can continue to pay off the first mortgage, but that second mortgage becomes an unsecured debt because the value of the house isn't enough to secure it. So, as with unsecured debts under Chapter 7, it can be written off.
If you don't qualify for either bankruptcy but have huge assets, can you file for a Chapter 11 bankruptcy?
An individual can file for Chapter 11, but it's not common and is usually very complex and expensive, costing up to $50,000. It's generally for bigger businesses, and is usually handled by corporate lawyers.
Medical costs are a big part of bankruptcy debt. Is there any situation when you can't get rid of medical debt?
Medical debt is the major reason people come in and talk about bankruptcy—and the collectors for medical debt can be more competitive and aggressive than any other type. You can eliminate it through bankruptcy, and there is no limit in Chapter 7, as it is an unsecured debt. But Chapter 13 has a limit of unsecured debts of $394,725. If your medical debt is higher than that, an experienced bankruptcy lawyer can help with strategy.
Are there alternatives to bankruptcy?
You can try to work out payment plans and consult with credit counselors and financial managers, but if the debt is too great this may not work. You can also work out a debt settlement, a lump sum that is less than you owe in forgiveness of entire debt. But be careful: make sure you a making a deal with the person who actually has the authority to make the deal stick? Also, that company may send you a 1099 for the settlement, which is basically a statement of income on which you will have to pay taxes.
Or you can go on the offense and look for violations on the part of your creditors or credit collectors to defend your rights. In that way, you may be able to reduce the amount of your debt to that creditor.
Something that is generally not a good idea is to refinance a mortgage or take on new loans to consolidate debt. It's difficult to borrow your way out of debt.
What should I look for when seeking professional help with bankruptcy or debts?
Always go with professionals you can trust. Be wary of "non profit" organizations that say they can help you work out debts at a reduced interest rate. The problem is many of these are scams, and there are thousands of them online. Do not do business with an online organization: go to a brick and mortar place where you can walk in and meet with them.
Also, don't go with some online "petition preparation services" promise to provide the same services as an attorney at a fraction of the price. In my experience, many of these providers are predators who give unlawful legal advice-and the advice given is usually incorrect. I've helped many people who have used those services.
About Judith Horstman