What is the Difference between Chapter 7 and Chapter 13 Bankruptcy?

by Neal Frankle, CFP ®

Even if you don’t owe a dime to a soul, it’s important for you to understand the difference between chapter 7 and chapter 13 bankruptcy .

Why?

Because somebody might owe you money and you better understand what happens if they declare the “Big B.”

A loyal Pilgrim reader happens to be a very friendly and helpful attorney (yes…it is possible) and she’s agreed to shed some light on this otherwise confusing subject.

Here’s Kimberly’s guest post. You can contact her on LinkedIn.

chapter 7 and chapter 13 bankruptcy

Bankruptcy is a gut-wrenching and emotional process, but as evidenced from recent statistics, is also an oft-used solution for debt problems. Bankruptcy is a means for one to shed debts in an orderly fashion that is fair to creditors so that the debtor may obtain a fresh start. Bankruptcy is far better than the original option, debtor’s prison, which was largely abandoned in the United States in 1833.

The bankruptcy process takes place in specialized courts within the greater federal court system and is overseen by a trustee from the Department of Justice. There are two chapters of the Bankruptcy Code which individuals use: chapters 7 and 13. In chapter 7, the trustee liquidates all assets to pay debts, and any remaining debt is erased (called a discharge). Some items are exempt from sale, such as clothing, pensions and alimony. A portion of the equity in vehicles, real estate, household goods and family heirlooms is also exempt. Practically speaking, the effort of selling often exceeds the return, so the trustee typically only sells high value items. Debtors who wish to use chapter 7 are subject to a monthly disposable income ceiling determined by a “means test,” otherwise they must use chapter 13.

In chapter 13, property is retained and a portion of debt is repaid over three to five years according to a plan. Monthly expenses allowed under the plan is a lifestyle greater than spartan living, but excludes spa days and vacations. While the debtor may keep property subject to loans, the debtor must afford the loan payments and also make up past-due payments, penalties and interest, lest the property be liquidated.

Creditors are paid in a priority scheme, starting with tax authorities, domestic support and case administration costs. Lenders that retain title in financed property are paid either through a return of the property or through collecting loan payments. Finally, unsecured creditors are paid (e.g. credit card companies, medical providers, utilities and the underwater portion of a loan for which the secured property was returned). In a marriage, one or both persons may file for bankruptcy, but if only one files, joint debts are not discharged.

Is there a difference between chapter 7 and chapter 13 in bankruptcy?

After paying debts through a chapter 7 or 13, most remaining debts are discharged. Taxes, DUI-related debts and domestic support payments are not discharged, nor are debts acquired in bad faith, i.e. in anticipation of shedding the debt in bankruptcy. Student loans are rarely discharged. After the completion of the bankruptcy process, creditors of discharged debt can no longer attempt to collect. A bankruptcy filing is reported on a credit report for about seven years. While it is not impossible to obtain credit after a bankruptcy, credit is much more expensive. This is a little perverse because an individual fresh out of bankruptcy has fewer debts so is more likely to repay the lender than before the bankruptcy.

The Bankruptcy Code is exceedingly more complicated than described above. Because the process relies on a combination of bankruptcy, federal and state law, it is advisable to consult an attorney or reliable debt counselor before filing. Few attorneys will take a case pro bono because every client claims an inability to pay. Bankruptcy is an extremely emotional process because one must lay open their financial affairs in a public setting where the court requires copies of all bank and credit statements and pay stubs. While the result of filing is not life-shattering (credit is only necessary for a lease or loan), it does hamstring financial flexibility and high-level job prospects (unless you are Donald Trump or Dan Snyder).

All that said – when is bankruptcy a good option? As a last resort when there is no viable way of repayment such as illness, disability, divorce or job loss. Before filing, exhaust all options such as cutting expenses, increasing income, returning secured property, debt consolidation and negotiating with creditors. There is no one-size-fits-all answer to whether it is a good idea to file for bankruptcy, due to differing debt instruments, situations, and state laws. While these are big options to weigh, the worst action is inaction.

Thanks, Kimberly. This is a subject I (thankfully) know little about, yet it’s really important. So…Pilgrims…have you ever been through this process? What was it like? Have you had someone who owed you money declare bankruptcy? What happened to the money they owed you?

OK…enough of all this talk. The weekend is upon us. Let’s get on to your weekend reading suggestions:

Here is a list of the carnivals I participated in. Lots of good finds.

Festival of Frugality

Carnival of Personal Finance

Festival of Frugality

Yakezie Carnival #6

Carnival of Personal Finance

Best of Money

Other posts of interest:

5 More Ways Group Disability Disappoints

Your guide to income based repayment.

The downside to store credit cards.

11 Most Missed Tax Deductions

Early Retirement – The Extreme Method

Teach Kids Finances

Use Credit Cards To Rebuild Your Credit

photo by The Truth About, Flikr

 

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