Choosing Chapter 7 vs Chapter 13 Bankruptcy

Considering bankruptcy can feel like being stuck between a very big rock and the hardest place on Earth. It's normal to feel confused or scared. 

There's a path ahead of you that can lead to a better financial situation, and you can step forward with more confidence once you understand the benefits and drawbacks of the various options that are available to you.

Bankruptcy is a serious solution for severe debt. Let's compare Chapter 7 and Chapter 13 bankruptcy and get an understanding of how they work. We'll also look at alternatives to bankruptcy, such as debt resolution or debt consolidation, in case neither kind of bankruptcy is right for you.

What is bankruptcy?

Personal bankruptcy is a federal court procedure that can protect you from bill collectors, get rid of your debts, and in some cases, help you repay your creditors. First, you file some paperwork with the court and pay fees. A bankruptcy judge determines what you can afford to repay and how you'll do it. Once you complete the court's requirements, debts that are eligible for forgiveness are discharged (wiped out). Some debts, called priority claims, can't be forgiven in bankruptcy. These include child support and many taxes and fines.

Chapter 7 bankruptcy: definition and overview

Chapter 7 bankruptcy is a "clean slate" or "liquidation" bankruptcy. With Chapter 7, you sell your assets (items of value that you own) to get rid of debt. 

You'll file the required forms and turn over your assets to a bankruptcy court. Most of your creditors must stop calls, letters, and lawsuits and wait for a judge to decide which things you'll give up. 

In bankruptcy, assets (the things you own) are either "exempt" or "non-exempt." You get to keep exempt assets in Chapter 7, but must usually surrender non-exempt assets. The court sells non-exempt assets and pays your creditors.

Read: Bankruptcy exemptions: what property can you keep?

After you complete the judge's requirements, you get a discharge (your debts are forgiven). The process usually takes less than six months.

Who qualifies for Chapter 7?

Not everyone qualifies to file Chapter 7. There are rules covering previous bankruptcy filings. Also, you must complete pre-bankruptcy credit counseling and meet income limits.

• Is your income less than or equal to the median income in your state for your family size? If so, you qualify for Chapter 7. Otherwise, you have to pass a "means test."

• The means test looks at what's left after allowed expenses (such as housing, groceries, deducted from your income. The allowed expenses can be found on Form 122-A.  

• If the result (your "disposable income") is enough to repay at least 25% of your unsecured debt over five years, you most likely fail the means test and can't file Chapter 7. 

Pros and cons of Chapter 7

Here are the potential benefits of Chapter 7:

• Speed—the process usually takes less than six months.

• Success rate—over 95%. 

Chapter 7 has a few potential drawbacks:

• Can't help with foreclosure or repossession.

• Creates a permanent public record and remains on credit reports for ten years. 

• You'll have to give up some property (non-exempt assets).

Chapter 13 bankruptcy: definition and overview

Chapter 13 bankruptcy requires you to repay at least some of what you owe. Chapter 13 is called a "wage earner's" bankruptcy because it's open to people who have enough income to repay at least some of their debts. 

You get to keep your property, but the value is factored into what you have to pay. By law, Chapter 13 filers must pay their creditors at least as much as they would if their property was sold under Chapter 7. A bankruptcy judge or trustee determines how much you can afford to pay into a plan. 

At the end of your plan, if you've followed the court's rules and made all payments, the judge issues your Chapter 13 discharge. That official action wipes out any remaining balances in your plan. 

Who qualifies for Chapter 13?

Not everyone can file Chapter 13. If you own a lot but have a low income, you might be forced into Chapter 7 instead. You must:

• Be up-to-date on your tax filings.

• Be employed with enough income to make the required plan payments.

• Be an individual, not a business.

• Complete pre-bankruptcy credit counseling no more than 180 days before filing.

• Have unsecured debt of $465,275 or less and secured debt of $1,395,875 or less. 

Read: Secured vs unsecured loans: understanding the difference

If the property you own that is unprotected by bankruptcy is valued too high, or if the debt prioritized by the bankruptcy court is too large, your Chapter 13 payment may not be affordable. 

Pros and cons of Chapter 13

Chapter 13 benefits include:

• You don't have to give up property. 

• You can include some debts that are excluded from Chapter 7. For example, if you paid your taxes with a credit card, you can get that debt discharged through Chapter 13 but not Chapter 7.

• You may avoid repossession or foreclosure of your car or house.

And here are some potential downsides:

• You must apply all of your disposable income for three to five years. 

• Attorney fees are higher compared to Chapter 7.

• Chapter 13 has a much lower success rate—under 50%. 

The low success rate is something to note. Lower-income filers are less likely to complete their plans. Chapter 13 plan payments are typically lower than what you contractually owe, so if your case fails you could find yourself even farther behind on your debts.

How to choose between Chapter 7 and Chapter 13

If you're trying to decide between Chapter 7 and Chapter 13, look at these key differences:

• Chapter 7 requires you to surrender non-exempt property. Chapter 13 lets you keep your assets but requires you to give up your disposable income for three to five years. What property would you lose in Chapter 7?

• Chapter 7 doesn't let you discharge every type of unsecured debt. Chapter 13 is more flexible. What kind of debt do you have?  

• Chapter 13 can stop car repossession and home foreclosure. Do you have past-due amounts on secured debt like an auto loan or mortgage?

• Chapter 7 eligibility includes income limits. There's no maximum income for Chapter 13. Can I pass the Chapter 7 means test?

You may want to avoid Chapter 7 if it means giving up things you want to keep. While Chapter 13 requires you to pay at least as much as Chapter 7, you'd be doing it over time and wouldn't have to surrender your property.

On the other hand, if your income isn't high, you don't own much, and you have high unsecured debt, Chapter 7 is on the table.

You'll need to find out what the bankruptcy exemptions and median income are for your state before you can answer all of these questions.

Another solution to consider: debt resolution

Bankruptcy isn't always the best choice if you have a lot of property to lose. Or if the amounts involved are lower, or you don't want a judge deciding what you'll pay. 

If you are struggling with overwhelming debt and considering bankruptcy, resolution is another possible option. Debt resolution could help you—and it's faster, with a higher success rate than Chapter 13 bankruptcy. The idea is to get creditors to accept less than what you owe and forgive the rest. They may be willing to do this if you can show that you really can't afford to pay off all of your debt—especially if you are dealing with a financial hardship such as a divorce, a medical emergency, or a major unexpected expense. 

There's a path to a better financial future. Get a free debt evaluation to discuss the possible directions you could choose.