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If you owe more money than you can pay back and your prospects for raising the funds seem non-existent, then you may need to declare bankruptcy. When most people do this, they are filing for Chapter 7 or straight bankruptcy, which completely liquidates their assets and eliminates all or most of their outstanding debts. While it provides immediate relief, it often means losing your home, vehicle, or other major possessions in the process. In contrast, Chapter 13 bankruptcy allows a debtor to keep their property, but they have to pay back all or some of their debts over a set time.
Rather than a complete liquidation, Chapter 13 is a reorganization of finances, and filers can still hold on to their house and discharge certain kinds of debts that would need to be paid under Chapter 7. There are some things that Chapter 13 bankruptcy can do for you that Chapter 7 can't – before you start the filing process, it's important to know which form of bankruptcy will work best for you.
How Chapter 13 Bankruptcy Works
Chapter 13 bankruptcy is essentially a structured payment plan that consolidates all of your major debts into one place. For people who want to repay their debts, Chapter 13 can provide protection against aggressive creditors and give them some maneuvering room that wouldn't necessarily be present otherwise. Some people choose Chapter 13 because it can prevent a foreclosure on houses or vehicles. While Chapter 13 allows you to keep your property, you have to pay back all or some of your debts over a three-to-five year period, and you must have the necessary money to fund a payment plan. Chapter 13 bankruptcy requires you to make your best effort at paying back your creditors, and present your plan in good faith and honesty.
When you file for Chapter 13, you're assigned a bankruptcy trustee from your local court. This trustee works with you to consolidate your creditors and debts into one large payment plan; every month you will pay the trustee the required amount and they will distribute the funds to your creditors. You must make every payment on time and in full in order to complete the plan; if you're successful, then your remaining debts after that will be discharged (be cancelled or forgiven).
While you may be able to have some of your debts discharged, you're still likely to be held responsible for repayment on the majority of your major debts. Chapter 13 bankruptcy divides your debts into several categories based on how much you'll need to repay. Certain obligations must be paid back in full, no matter what; these include priority payments, such as child support and alimony, and secured debts like car loans and mortgages. Any money left after making these payments (and necessary living expenses) is called 'disposable income.' All of it will be split among your unsecured creditors (like medical and credit card bills) who will receive a percentage of what you owe. Many Chapter 13 filers will only pay a small portion of their unsecured debts through the payment plan.
How much unsecured debt will you need to repay? This is calculated based on a number of factors. The first test, referred to as the "best interest of creditors", figures out the minimum amount that your unsecured creditors would have received if you'd filed for Chapter 7 bankruptcy. You have to pay that minimum back to them at the very least. The courts also use what's called a means test (this is used to gauge your financial hardship) to determine how much disposable income you have, in order to know how much each creditor will get from you. This also is used by the court to decide if you qualify for Chapter 13 or Chapter 7 bankruptcy.
A Chapter 13 bankruptcy payment plan lasts between three and five years, depending on how much you earn and how much you owe. Once you've completed the plan, all remaining debts eligible for discharge are eliminated from your record so long as you're current on obligations like child support payments and can prove that you have completed a budgeting education course. The record of your bankruptcy declaration will remain on your credit report for ten years, which is standard for nearly all types of bankruptcy.
Chapter 7 or Chapter 13 Bankruptcy?
In order to understand Chapter 13 bankruptcy, it's good to know how it differs from traditional liquidation. When you file for Chapter 7 bankruptcy, you turn over your assets to a trustee who sells whatever they can to generate money to pay back your creditors.
There are two types of debt:
- Secured debts, like car loans or mortgages, which are insured with collateral at the time of the loan or with a lien claim if you aren't paying on time; and
- Unsecured debts, like credit card bills, which do not have any material consequence if they're not repaid (meaning you won't lose your house or car as an immediate result).
Chapter 7 bankruptcy takes care of secured debts by either turning over the property you used as collateral or paying back as much as possible. After the liquidated assets run out, most of the remaining unsecured debt is discharged completely and is no longer owed. A Chapter 7 bankruptcy claim is typically closed within six months of filing, and the person can potentially emerge from the process completely debt free, depending on the type of obligations they had.
Key Differences Between Chapter 13 and Chapter 7
The largest difference between the two is that Chapter 7 bankruptcy often involves losing your property. If you've defaulted on a mortgage or car payment and you want to keep your home or automobile, you'll still have to make the payments. There are some types of unsecured debts, like student loans and tax obligations, which cannot be discharged under Chapter 7 and which still must be paid off. Further, some people aren't eligible for Chapter 7 bankruptcy at all. Thanks to a revision of the national bankruptcy laws (the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005), you can't apply for liquidation if you fail a means test, or if your disposable income is high enough that the court determines you can reasonably pay your debts.
In Chapter 13, you're able to keep your property, which can prevent a lot of upheaval, loss, and chaos during an already stressful time. It's also beneficial if you have a cosigner on a loan; under Chapter 7, that person will still be liable for paying back your debts even if you're not, but under Chapter 13, they are protected from liability. It's a useful plan for those with student loans or tax obligations, which can be very costly and cannot be discharged under liquidation. However, Chapter 13 does require a significant financial commitment for a longer period, and you remain responsible for your obligations. It's important to consider all of these factors when contemplating the best type of bankruptcy plan for your case, and weigh the impact of each one.
To learn about other kinds of bankruptcy, you can read more on
- Chapter 7 (the kind of bankruptcy that results in liquidating or selling off assets);
- Chapter 9 (a famous recent example of this is the Detroit bankruptcy);
- Chapter 11 (a common form of bankruptcy for businesses); or
- Chapter 15 (which determines where the bankruptcy proceedings are held)
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