Understanding Bankruptcy: Chapter 7 vs Chapter 13

If you’re desperately in debt, you might be considering bankruptcy, the most drastic debt solution. But which form of bankruptcy should you choose? Chapter 7 or Chapter 13? Both forms of bankruptcy create public records and take place in a state or federal Bankruptcy Court. However, the two filings have very different requirements. There are also differences in the way each chapter impacts your finances and your credit rating. This article covers the differences between Chapter 7 and Chapter 13 bankruptcy to help you choose a bankruptcy filing. 

What Is Bankruptcy?

Bankruptcy is a federal court proceeding that provides relief from creditors to consumers and businesses. If you are legally entitled to file for bankruptcy protection, your creditors must stop collection efforts until the court can review your case. This is called an “automatic stay.” 

The possible outcomes of a bankruptcy filing are:

• Liquidation (Chapter 7)

• Reorganization (Chapter 13, Chapter 11)

• Dismissal (the judge denies your bankruptcy or you voluntarily withdraw your filing)

The type of bankruptcy you file determines how your debts will be reorganized or liquidated. 

How to File Bankruptcy

You can file a bankruptcy yourself or with an attorney. Your first step is determining which type of bankruptcy you will file. Here are the steps you’ll take. 

If you want to file Chapter 7, you have to pass a “means test.” First, you complete a Statement of Your Current Monthly Income (Form 122A-1) to see if your earnings are below your state's median income. If they are, you qualify for a Chapter 7 bankruptcy. 

If your income is higher than the median income, you complete Form 122A-2, Chapter 7 Means Test Calculation. On this form, you'll deduct allowed expenses and see if you have enough income to pay into a Chapter 13 bankruptcy plan.

If you pass the means test, you must complete Schedule I: Your Income and Schedule J: Your Expenses. If you have enough remaining to pay something to your creditors after deducting your actual monthly expenses from your current monthly income, the court might convert (switch) your Chapter 7 case to a Chapter 13 bankruptcy.

If you are eligible for a Chapter 7 filing, you’ll follow the steps outlined by the US Bankruptcy Court. If you don't pass the means test, you’ll have to file Chapter 13 bankruptcy, which is more complicated. 

To qualify for Chapter 13 bankruptcy, you must have regular income and be current with your income tax filings. You can’t have filed a Chapter 13 bankruptcy within the last two years or a Chapter 7 within the last four years. Your unsecured debt cannot exceed $419,275, and your secured debt cannot exceed $1,257,850. If your debt is too high for a Chapter 13, you’ll have to consider Chapter 11, which is usually filed by businesses but is open to individuals. 

The US Bankruptcy Court offers these guidelines for filing Chapter 13. 

For either bankruptcy, it’s critical that you follow the court procedures exactly, or your case might be dismissed. 

Here are some common reasons for involuntary bankruptcy dismissal:

• Bankruptcy schedules and other forms not filed on time

• Missing 521 documents, like tax returns

• Failure to pay the court filing fee

• Missing the 341 meeting of creditors

• Not making all Chapter 13 plan payments

• Not paying child support or alimony during the case

• Failure to supply complete and truthful information in your paperwork

• Not completing required credit and debt counseling

In many situations, you can head off a dismissal by providing required documents or correcting paperwork. However, abusing the system, for example running up credit card balances shortly before filing or excluding assets in your paperwork will likely get your case dismissed with prejudice, which means you won’t be allowed to file bankruptcy for a period of time or may even be barred from ever filing. 

What Is Chapter 7 Bankruptcy?

Chapter 7 is a liquidation bankruptcy. When you file a Chapter 7 bankruptcy, you get an automatic stay, meaning your creditors cannot pursue you for repayment. The court examines your income, debts and assets. You’ll be allowed to keep some of your assets, called exempt property. Each state has its own rules about what you’re allowed to keep, and some are more generous than others. 

If you are not paying your secured debts like an auto loan or mortgage, your property will probably be repossessed. Your other non-exempt property is taken and sold, and the proceeds are distributed to your creditors. Any remaining balances are discharged. You do not have to pay taxes on debt forgiven in bankruptcy. Chapter 7 filings are public records and can stay on your credit report for ten years.

Pros and Cons of Chapter 7 Bankruptcy

Chapter 7 may not be the best option for you even if you qualify. Here are the pros and cons so you can decide for yourself.

Chapter 7 Pros

• You can get out of debt in three to six months.

• Your creditors must stop collection activity as soon as you file.

• State exemptions allow you to keep some of your property.

• Anything you earn or buy after filing cannot be taken.

• Discharged amounts are not taxable.

Chapter 7 Cons

• You may lose possessions that mean a lot to you. 

• You have to close all of your credit cards.

• It will be difficult and expensive to get credit for a few years. 

• You can’t discharge student loan debt, alimony, or child support.

• Filing bankruptcy might affect your employment in certain industries like financial services.

Chapter 7 might provide the clean slate you’re looking for. Or you might choose to file Chapter 13.

What Is Chapter 13 Bankruptcy?

Chapter 13 is known as the “wage earners” bankruptcy. When you file a Chapter 13 bankruptcy, you also get an automatic stay from collection attempts by your creditors. You submit forms detailing your income, assets and debts, and the bankruptcy trustee determines a monthly payment that you must make over a three-to-five year period. (Most filers make five years of payments.)

If you keep your paperwork current and make all of your payments, your bankruptcy will be discharged, and any remaining balances are forgiven and not taxable by the IRS. Chapter 13 does not force you to surrender any assets. 

Pros and Cons of Chapter 13 

Chapter 13 may be your only choice available, or it might be a better fit for your situation.

Chapter 13 Pros

• You may get out of debt for less than you owe.

• Forgiven amounts are not taxable. 

• You get better terms for debt repayment – more time to repay or a more affordable payment.

• You get to keep your property while you’re making payments. 

• Getting credit after filing Chapter 13 can be easier – for instance, FHA allows you to get a mortgage after 12 months of on-time payments into your plan.

• Many creditors view Chapter 13 as less severe than Chapter 7, and you may have an easier time getting credit.

Chapter 13 Cons

• Chapter 13 takes longer to complete – three to five years.

• The trustee determines your payment, and it might be higher than you’d like.

• Chapter 13 does not get you out of student loan debt, child support or alimony. 

• The commitment can be too much for many filers. Chapter 13 has a success rate of just 40% to 70%, depending on the state, while Chapter 7 has a 95% success rate according to the American Bankruptcy Institute (ABI)

Chapter 13 can be a good way to get out of debt, especially if you have a lot of debt and want to keep your property. 

Bankruptcy: Which Is Better: Chapter 7 or Chapter 13?

The right bankruptcy choice for you depends on your circumstances. If your income is low enough to qualify for Chapter 7 and you don’t have much non-exempt property, Chapter 7 can be the right choice. However, even if you qualify for Chapter 7, you might be better off with Chapter 13 if you have property that you don’t want to lose. 

Here’s an example of someone for whom Chapter 7 is probably the right choice: 

Jane lost her job during the pandemic and had to survive on side gigs. She eventually got a job that pays less than she was earning before. Jane fell behind on her rent and owes her landlord about $9,000. She continued to make the minimum payments on her credit cards so she could keep charging food, gas, and other essentials, but now she is maxed out. She is a month behind on her car loan and about $2,500 in medical debt for an ER visit after she lost her job and health insurance.

• Jane has no non-exempt assets.

• Her debt is mostly unsecured – medical, credit cards and back rent.

• Her car is inexpensive and she has little equity in it, which means her state considers it exempt property.

• Jane’s income is low enough to qualify for Chapter 7. 

Jane is a good candidate for Chapter 7 because she has no property to lose. She can afford her car payment and rent if the other obligations go away. 

And here is a person for whom Chapter 13 might be a better option.

Joel is a restaurant owner who lost his business during the pandemic. He survived on credit cards and covid relief payments, but his balances are sky-high and his mortgage lender is threatening foreclosure. Joel has an art collection that he inherited from his grandparents, and it means a lot to him. He also owns an expensive car that has no loan on it. He recently took a job managing a high-end restaurant, and it pays well enough to cover his current bills but not the debt he piled up during COVID. 

• Joel has assets he doesn’t want to lose.

• His income is sufficient to repay some of what he owes over time.

• He has a mortgage that he can bring current if his debts are reorganized..

Joel is probably a good candidate for Chapter 13 because he has property to protect and a steady income that will help him repay some or all of what he owes in three to five years.

Bankruptcy Alternatives

Bankruptcy is not right for everyone with debt problems. You might not want to turn over your financial decisions to a bankruptcy court. You might not want someone else telling you what property you must sell or how much income you have to pay. And you might not want your debt issues to become public. 

In that case, consider bankruptcy alternatives like debt management or debt settlement. 

Debt management plans (DMPs) are similar to Chapter 13 bankruptcies in that you pay into a plan and a credit counselor distributes that payment among your creditors. This payment may be lower than the total of your obligations because creditors are often willing to reduce your payment and/or interest rate when you’re in a plan. However, creditors are not required to make concessions and your payment may be too high to afford. Debt management does not reduce what you owe.

Debt settlement is similar to Chapter 7 in that your debts may be discharged for less than you owe. You or a debt settlement company working for you negotiate an amount with your creditors. You pay a lump sum in exchange for the creditor forgiving your debt. However, creditors are not required to settle with you and there is no guarantee that they will. In addition, forgiven amounts are taxable unless you are insolvent. If you qualify for Chapter 7 but choose to settle debts instead, you may be insolvent and exempt from tax on forgiven amounts.