Here are some things to think about before you decide to file for Chapter 7 or Chapter 13 bankruptcy.
By Cara O’Neill, Attorney
For many individuals, filing for bankruptcy relief can provide a way out of debt and a fresh financial start. But whether a bankruptcy filing is in your best interest will depend on many factors and your circumstances. Read on to learn more about what to consider if you are thinking about filing for Chapter 7 or Chapter 13 bankruptcy.
Is Bankruptcy the Best Choice?
Bankruptcy will impact your credit score for years to come. So it’s a good idea to evaluate all of your options before deciding to file for bankruptcy. Many creditors are willing to work with debtors to settle their debts. If you can resolve your financial issues outside of bankruptcy, you might not need to file for bankruptcy.
To learn more about your options, see Alternatives to Bankruptcy.
Should You Choose Chapter 7 or Chapter 13 Bankruptcy?
Chapter 7 bankruptcy works well for people who can protect all of their property with exemptions, whose income is low enough to meet qualification requirements, and whose debt is the type that bankruptcy will discharge.
By contrast, Chapter 13 bankruptcy works best for people:
- whose income is too high to qualify for Chapter 7 bankruptcy
- who would like to save a house from foreclosure or a car from repossession, or
- who want to pay back nondischargeable debt, such as back child support or income tax debt, through a three- to five-year repayment plan.
So when considering whether it’s in your best interest to file for Chapter 7 or Chapter 13 bankruptcy, keep in mind that it will depend on numerous factors including:
- the type of debts you owe
- your income and expenses
- whether you’ll lose property, and
- what you hope to achieve with bankruptcy (such as keeping a house or car).
To learn more about when it makes sense to file for Chapter 7 or Chapter 13 bankruptcy, see When Chapter 7 Bankruptcy Is Better Than Chapter 13 Bankruptcy and When Chapter 13 Bankruptcy Is Better Than Chapter 7 Bankruptcy.
Will Bankruptcy Wipe Out Your Debt?
Before you file your case, you’ll want to think about the goals because a bankruptcy discharge doesn’t eliminate certain types of debt (called priority obligations). For instance, you can wipe out most credit card obligations, medical bills, and personal loans. But you can’t discharge domestic support obligations (such as child and spousal support), newer tax debt, student loans (unless you can prove undue hardship), and more.
The bottom line is that filing for bankruptcy might not be in your best interest if you can’t get rid of your debt. However, bankruptcy can help in other ways. For instance, you can pay off nondischargeable debt over three to five years in a Chapter 13 case.
Is Your Lender About to Foreclose on or Repossess Your Property?
If you have debts secured by your property (such as a mortgage or car loan), your lender can foreclose on the home or repossess the car if you default on your obligation (or take any other property that serves as collateral for the debt). Your lender has this right because of the lien you agreed to when you took out the loan.
In most cases, you can’t wipe out your lender’s lien on the property with a bankruptcy discharge. Even after the bankruptcy, if you don’t make the loan payments, the lender can take back the property.
However, bankruptcy’s automatic stay can stop or delay the foreclosure and repossession process. The relief afforded by the stay in Chapter 7 bankruptcy is usually temporary. But filing for Chapter 13 bankruptcy might allow you to:
- keep the property and catch up on your missed payments
- reduce the balance of your loan if you qualify for a cramdown, and
- eliminate wholly unsecured junior liens from your house through a process called lien stripping.
Are You Facing a Collection Action, Garnishment, or Lawsuit?
If you don’t make the required payments on your debts, your creditors can take you to court to recover their money. A creditor that obtains a judgment against you in court can use it to garnish your wages or place a lien on your assets. Some creditors, like the IRS or your student loan lender, can take action without stepping into the courtroom. (Learn more about the ways that creditors can collect debts.)
When you file for bankruptcy, an automatic stay goes into effect that stops almost all collection actions, including lawsuits and garnishments. Filing for bankruptcy relief can also eliminate the underlying debt.
For more information on bankruptcy and collection activities, see Bankruptcy’s Automatic Stay.
Can You Protect Your Property?
One of the most important things to consider before filing for bankruptcy is whether you’ll be able to keep all of your property. Bankruptcy exemptions allow you to protect a certain amount of assets in any bankruptcy chapter that you file. What will happen to nonexempt assets will depend on whether you file a Chapter 7 or Chapter 13 bankruptcy.
- Chapter 7 bankruptcy. A Chapter 7 bankruptcy trustee has the authority to sell any assets you can’t exempt and to use the proceeds to pay back your creditors.
- Chapter 13 bankruptcy. You can keep all of your property in a Chapter 13 bankruptcy. However, you’ll have to pay your unsecured debts (such as credit card balances, medical bills, and personal loans) at least an amount equal to the value of your nonexempt assets. If you have a significant amount of nonexempt property, filing for bankruptcy might not be in your best interest.
What Is Exempt Equity?
People who file for bankruptcy don’t lose all of their possessions. A bankruptcy filer can protect—or exempt—a certain amount of assets regardless of the bankruptcy chapter filed. The dollar amount of an ownership interest that you can protect is called “exempt equity.”
Calculating exempt equity is a two-step process. First, you’ll find out how much of an item’s value you can protect, or “exempt.” You’ll do so by consulting your state’s exemption statutes.
Although some exemption statutes tell you the number of items that you can protect, such as one motor vehicle or all prescribed health aids, others allow you to keep property valued up to a particular amount. For instance, you might be able to retain $50,000 in a home or $10,000 in household items. The dollar amount tells you how much equity you can exempt.
The next step is figuring out how much equity you have in your property (the funds remaining after selling the property and paying off any outstanding loans).
Suppose, for instance, that you were considering selling your house. To figure out the amount of your equity for bankruptcy purposes, you’d subtract your mortgage from the market value (the price your house would sell for). The remaining amount would be your equity.
By contrast, if you own a bicycle free and clear, you’d be entitled to all sales proceeds. Therefore, your equity would be its market value.
You can own property without equity, too. If you do, you won’t use an exemption because there won’t be anything to protect.
Example. Audrey took out a loan to buy a $20,000 car. When she filed for bankruptcy, she owed $15,000. However, the car’s value dropped to $10,000. Because the lender would receive all of the sales proceeds if the vehicle were sold (the $10,000 value equaled the amount owed to the lender), Audrey didn’t have any equity to protect with an exemption.
Do You Qualify for Bankruptcy?
Both Chapter 7 and Chapter 13 bankruptcy have eligibility requirements. Your income must be low enough to pass the Chapter 7 means test. By contrast, in Chapter 13 bankruptcy, the amount you owe cannot exceed certain dollar limits. Also, you must have enough income to support your Chapter 13 repayment plan.
For more information on whether you qualify for bankruptcy, see The Means Test & Other Chapter 7 Eligibility Issues and Are You Eligible for Chapter 13 Bankruptcy?