The Different Degrees of Bankruptcy, Explained

If you’re thinking about filing for bankruptcy protection because you’re overwhelmed with bills, you need to know the difference between Chapter 7 and Chapter 13 bankruptcy. Chapter 7 is sometimes called “liquidation” or “straight liquidation,” and it’s usually the fastest and easiest form of bankruptcy. Individuals, married couples and businesses can use Chapter 7 bankruptcy protection to get rid of unsecured debts and various financial obligations, such as:

  • back rent
  • civil judgments
  • collection accounts
  • credit card debt
  • medical bills
  • overdue utilities
  • payday loans
  • various personal/consumer loans

But don’t think that filing Chapter 7 bankruptcy will be the answer to all your financial woes. It won’t, because Chapter 7 doesn’t eliminate some debts, including student loans and most back taxes, along with court-ordered alimony and child support.

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To qualify for Chapter 7, you must also obtain credit counseling, and pass an “income test” and a “means test.” If you do not meet the requirements for Chapter 7, you will be moved from Chapter 7 into Chapter 13 bankruptcy for a repayment plan that can last for up to five years.

Lawyers also often advise people trying to prevent foreclosure and individuals who have secured assets that they want to keep (like a home, car or boat) to file Chapter 13 bankruptcy, instead of Chapter 7.

A Primer on Chapter 13 Bankruptcy

Unlike Chapter 7, which can completely wipe out unsecured personal debts such as credit card bills and medical debt, Chapter 13 is a way to reorganize your finances and pay off some or all of your debts over a period of three to five years.

Chapter 13 is also known as a “wage earner’s plan,” because individuals in this form of bankruptcy must have a regular income and provide a plan to the court showing that the person can repay all or part of his/her debts.

To do a Chapter 13 filing, the courts require that a debtor first gather a slew of information, including creditors’ names, addresses, and the amount of debt owed to each.

A person filing bankruptcy must also put together a variety of “schedules”—namely, an income and expense schedule, a schedule outlining his or her assets and liabilities, and a schedule showing unexpired leases and executory contracts (i.e., those where a borrower has a material unperformed obligation).

Lastly, the debtor must provide the Bankruptcy Trustee with a statement about the individual’s financial affairs. Taken together, these documents will give the Chapter 13 Trustee a sense of one’s overall financial picture.

With a Chapter 13 filing, the court issues an “automatic stay” protecting a bankruptcy filer from further actions by creditors. This means creditors can’t initiate or continue any collection activity against you, including foreclosure, lawsuits, repossession, wage garnishments, or even just harassing phone calls.

Therefore, a Chapter 13 filing can also be used to keep certain assets, such as a home or car. Also, under Chapter 13, when there are co-signers on debts such as a mortgage, both people on the loan do not have to actually file for bankruptcy in order to reap the legal and financial protections afforded by bankruptcy.

This is good news for co-signers of debts because with a Chapter 13 petition, the filing also provides a “co-debtor stay,” which means that creditors can’t try to collect a consumer debt from another individual who is also liable with the debtor for the debt.

Since bankruptcy is a major financial decision, before you file for bankruptcy protection, make sure you evaluate all your options—and only do it as a last resort. You should investigate getting budgeting help, assistance from a non-profit credit counseling agency, or entering into a debt management plan before you turn to bankruptcy.

But if you find that it is necessary, bankruptcy can often be the financial solution that gives you the fresh start you need to get your finances back under control.

Lynnette Khalfani-Cox is a personal finance expert and co-founder of the free financial advice site, AskTheMoneyCoach.com. Follow Lynnette on Twitter @themoneycoach and Google Plus.