When you’re deeply in debt, paying back what you owe might feel impossible. This can happen for many reasons, from big medical bills to a job loss to divorce. Fortunately, there’s a solution under U.S. law to help you escape from debt you can’t pay back so you aren’t stuck for life.
You can file for bankruptcy.
There isn’t just one type of bankruptcy, though. There are two primary types of bankruptcy consumers can file for: Chapter 7 bankruptcy and Chapter 13 bankruptcy. There are also other kinds of bankruptcy as well, including Chapter 11, which is frequently used by businesses that need to restructure. But, for most consumers, Chapter 7 or 13 are the best or only options.
Each type of bankruptcy is named for chapters in the bankruptcy code that set the rules for filing. The bankruptcy code is a part of U.S. federal law, so the rules are largely the same no matter where you live — although individual states set some of their own guidelines as well, especially related to what happens to your assets during bankruptcy.
Because both options provide relief for consumers, it’s important to make an informed decision about which type is right for you. There are big differences between Chapter 7 and Chapter 13, both in terms of who is eligible and how the bankruptcy process will work to help you find relief from debt.
What is Chapter 7 bankruptcy?
Chapter 7 bankruptcy is available to people who have limited income. You’ll have to pass a means test to show your income is low enough to file Chapter 7. Here’s what it takes to pass the means test:
- Your current income must be below the median income in your state for your household size. Use Form 122A-1 to determine income for this test.
- Your disposable income must leave you too little money to pay your debt after you pay for essential expenses, such as housing, required union dues, child support, and insurance. Use Form 122A-2 to determine if you can meet this test.
Those who qualify for Chapter 7 have to turn over some assets to the bankruptcy estate as part of the bankruptcy process. That’s why this type of bankruptcy is also known as a liquidation bankruptcy — the assets you turn over are liquidated to pay back money owed. This includes non-exempt assets and non-retirement investment accounts, expensive cars or jewelry, and real estate that’s not your primary home.
Some assets are exempt, meaning you can keep them. Different states can set rules for which property is exempt and non-exempt within their state. Usually some equity in your primary home and an inexpensive car are exempt. Retirement accounts such as 401(k) and IRAs are exempt too, as is some personal property and tools or equipment you need to earn a living.
What is Chapter 13 bankruptcy?
If you can’t pass the Chapter 7 means test because your income is too high, you’ll likely file for Chapter 13 bankruptcy.
There’s a big upside to filing for Chapter 13 over Chapter 7. None of your property has to be liquidated as part of the bankruptcy process. This means you can keep your belongings while still getting relief from debt.
But there’s also a catch.
Wage earner bankruptcy
You have to work on paying back creditors over time, which is why this type of bankruptcy is referred to as wage earner bankruptcy. In fact, you have to work with the court and your creditors to develop a three to five year repayment plan (also known as a wage earner plan) in which you pay back at least a portion of your debt. Chapter 13 doesn’t provide fast relief for borrowers because you’ll be required to stick to this payment plan for your bankruptcy to be completed.
If you can’t follow the terms of the plan, your bankruptcy might be dismissed, or you could request to convert the bankruptcy to a Chapter 7. You may also request a modification if your circumstances change during repayment. But this would need to be approved and there’d have to be a good reason to change what you agreed to.
Chapter 7 vs. Chapter 13
The two big differences between Chapter 7 and Chapter 13 bankruptcy relate to eligibility and what happens to your debt after you file. Keep in mind, if you make too much money, you can’t qualify for Chapter 7 bankruptcy.
What happens to your debt: When you file Chapter 7, the remaining balance of eligible debt is discharged after assets have been liquidated, and the proceeds are used to repay creditors.
With a Chapter 13, the remaining balance of debt isn’t discharged until after you’ve completed your three to five year payment plan.
So, while you get to keep your property in Chapter 13, it takes much longer to go through the bankruptcy process. And your creditors will likely be paid back more under a Chapter 13 than they would’ve been under a Chapter 7— although this depends on how many assets you had and their value when liquidated.
Is it better to file a Chapter 7 or 13?
|Chapter 7||Chapter 13|
|Type of bankruptcy||Liquidation Bankruptcy||Wage Earner’s Bankruptcy|
|Who can file||Those who can pass a means test. Your income needs to be below the state median or you need too little disposable income to pay back debt||Wage earners who can afford to make monthly payments to creditors over three to five years|
|Biggest benefit||Quick discharge of eligible debt||You don’t have to give up your property to be liquidated|
|Biggest drawback||You may have non-exempt property sold to pay back creditors||You have to complete a three to five year repayment plan|
|How long it takes to receive a discharge||Around four months after filing bankruptcy||Around four years after filing bankruptcy, although it could be as long as five years|
|What happens to property||Non-exempt property is sold||You can keep most property|
|Are unsecured junior liens from real property removed through lien stripping?||No||Sometimes|
|Are principal loan balances on secured loans reduced?||No||Sometimes|
How bankruptcy can help you
Bankruptcy provides important protection to those with too much debt to repay. There are a few key ways bankruptcy can provide you with relief, including the following:
Bankruptcy stops collection efforts
This occurs because an automatic stay goes into effect as soon as you file bankruptcy and prevents creditors from continuing to try to collect against you. There are some limited exceptions, such as if you’ve very recently had a bankruptcy.
Having an automatic stay in place means creditors have to stop collection calls and can’t continue pursuing legal actions, including foreclosures or repossessions. Wage garnishment is paused. Creditors can ask the court to let them continue collection efforts by filing a motion for relief from automatic stay, but the court won’t always let them. And the automatic stay buys time to try to negotiate with creditors or get current on debt to stop foreclosure.
Even before you have filed bankruptcy, the Fair Debt Collection Practices Act (FDCPA) protects your rights when you owe money. Under the act, collectors are limited in the actions they can take to try to collect. For example, they can’t call you too early or too late, call you at work if you ask them not to, or make threats of legal action they don’t intend to carry out. They must also provide proof of your debt. And if you request they stop contacting you, they must comply — although they can continue collection efforts and you’ll still receive notification of legal actions such as lawsuits filed against you.
You can discharge debt
When debt is discharged, you no longer owe the amount that was due. Only some debt is eligible to be discharged, including unsecured debt such as credit cards and medical bills. Unsecured debt is different from secured debt.
Unsecured debt is debt with no collateral, whereas secured debt has an asset guaranteeing the loan. Secured debt typically must be paid back in full unless you give up the asset serving as collateral, but there are some exceptions. The time when eligible debt is discharged — and requirements you must fulfill — vary depending whether you file Chapter 7 or Chapter 13.
You can work on improving credit
Bankruptcy can do serious damage to your credit. But it can also be the first step toward fixing your credit as well. When maxed out credit accounts and late payments are reported every month because you’re overwhelmed with debt, this hurts your credit score.
Bankruptcy gives you a fresh start. After your debt is discharged, you can open a secured card and start paying on time. As you build a positive history of payments, your old bankruptcy and the older negative information on your credit report matters less.
The type of debt you have, and the type of bankruptcy you file, will affect the ways in which bankruptcy affects you.
Will I need to repay all of my debt with a Chapter 7 or Chapter 13?
In most cases, you don’t repay all of your debt when you file for either Chapter 7 or Chapter 13.
With Chapter 7, most creditors receive payment only from your savings and the proceeds of the sale of your assets. The remaining balance doesn’t have to be paid back. With Chapter 13, most creditors receive only the money you pay under your repayment plan, and the remaining balance is discharged.
But not all debt can be discharged in bankruptcy, which means it won’t go away even if you have successfully gone through the bankruptcy process.
Debts you can’t discharge include:
- Certain kinds of tax debt, including payroll taxes or recent IRS tax debt for unpaid income taxes
- Student loan debt, unless you pass the Brunner test or meet similar criteria depending where you live.
- Unpaid child support or alimony, unless the alimony was part of your property division during a divorce.
- Debt incurred due to fines, penalties, and restitution resulting from a crime, except fines intended to repay the government rather than fines intended as a punishment.
- Debt incurred due to DUI drunk driving damages if you caused a drunk driving accident
Secured debt is also treated differently than unsecured debt. Secured debt is debt for which there’s collateral. The two most common examples are mortgages and car loans. Your home is the collateral that secures your mortgage loan, and your car secures your auto loan.
If you file Chapter 7, you typically have to pay off these debts — or reaffirm them and keep making payments in order to keep the house, car, or other collateral. When you reaffirm the debt, you promise to pay it back. Sometimes you may be able to get your creditors to agree to a different payment plan or different payment terms. But these negotiations aren’t a standard part of the bankruptcy process, and the court won’t change the terms of your loan.
If you file Chapter 13, you usually have to pay off secured debt or reaffirm it and keep making payments, just like with Chapter 7. However, cramdowns or lien stripping could also be possible options.
A cramdown occurs when the balance of your secured debt is reduced to the fair market value of the property.
For example, if your car is worth $2,000 but you owe $3,000, you may be eligible for a cramdown. The balance of your secured debt would be reduced to $2,000, and the remaining $1,000 would be considered unsecured. It would then be treated just like other unsecured debt, such as credit card debt, in your Chapter 13 plan. Since you don’t usually pay back all of your unsecured debt in your payment plan, a portion of your car loan balance would be discharged.
Cramdowns are an option for investment properties but not a primary home. They’re also an option for cars you’ve owned for at least 910 days prior to bankruptcy.
Lien stripping is an option for primary homes — but only if you have more than one loan. Your junior loans, which are mortgages or home equity loans other than your first mortgage, could be reclassified as unsecured debt as a result of lien stripping. This can happen if the home isn’t worth more than the value of the first mortgage.
If you owe $250,000 on a primary mortgage and the home is worth $200,000, your second mortgage wouldn’t be secured since foreclosure wouldn’t give the second mortgage lender any money. The lien could be stripped from the second mortgage, so it’d be reclassified as unsecured debt and could be included in your Chapter 13 repayment plan with other unsecured debts.
How to decide which type of bankruptcy is right for you
To decide if Chapter 7 or Chapter 13 is right for you, first consider if you can pass the Chapter 7 means test. If you can’t, you’ll have no choice but to file Chapter 13.
If you could be eligible for Chapter 7 but don’t want to give up your property, you’ll have to determine if you have the funds available to make payments under a Chapter 13 repayment plan.
If you’re interested in lien stripping or a cramdown to help you keep property secured without paying off the loan in full, it may also be worth trying to file Chapter 13, as long as you can afford the payments.
Before you file either type of bankruptcy, be sure to check if your debts are eligible for discharge and explore other options for how to pay off debt, such as debt settlement, which could be less damaging to your credit. By considering the pros and cons of each option and determining what each could mean to your financial situation, you’ll be in a good position to make an informed decision on how to proceed.