If you are facing a significant amount of debt and are contemplating filing for bankruptcy, you may be wondering, “Should I Get a Chapter 7 or Chapter 13?”. It’s important to understand the differences between Chapter 7 and Chapter 13 (and, even Chapter 11 if you’re a business owner). Both options provide a way to eliminate qualifying debt and start anew financially, but the choice between the two depends on your specific financial circumstances.
Understanding Chapter 7 Bankruptcy
Chapter 7 bankruptcy involves the liquidation of non-exempt assets in order to repay creditors. Any remaining dischargeable debts (usually unsecured creditors), such as credit card balances, personal loans, medical bills, and even some student loans, are eliminated. To be eligible for Chapter 7, individuals must pass a means test that demonstrates their income is below the median levels in their state.
The advantages of Chapter 7 include the rapid relief of debt and the discharge of a majority of unsecured debts. On the other hand, the disadvantages entail the loss of non-exempt property and potential damage to one’s credit.
What is considered, non-exempt property?
Non-exempt property, thus something that may be required to be liquidated to pay creditors, can include things such as a vacation or second home, a second car (if not needed for work), expensive furnishings, boats & recreational vehicles, hobby equipment and musical instruments (if not used to generate income). This list is not exhaustive. It’s really up to the presiding judge to determine what is and isn’t exempt in your particular case which is why having a good bankruptcy attorney to help you decide which direction works best for your circumstance.
Understanding Chapter 13 Bankruptcy
Chapter 13 bankruptcy (AKA “Reorganization Bankruptcy”) provides individuals with the opportunity to restructure their debts over a 3-5 year repayment plan approved by the court. This plan is based on your income and allows you to retain your personal property by making regular monthly payments. After completing the plan, any remaining debts can be discharged. To be eligible, you must have a steady income, as well as limited unsecured or secured debts as defined by the bankruptcy code.
Some benefits of property retention and payment consolidation include the ability to catch up on payments, prevent foreclosure, and potentially minimize credit damage. However, there are also drawbacks such as the requirement of strict repayment plans and close court supervision.
Determining if Chapter 7 is the appropriate option.
Chapter 7 bankruptcy may be a viable option for individuals with primarily dischargeable debt, limited disposable income, and no significant assets or property to retain, as it offers a more expedited form of debt relief.
It’s similar to ripping a bandage off of a wound. It’s going to hurt, but the healing process can begin quicker than with a Chapter 13 bankruptcy, assuming you’re willing to risk losing certain non-exempt property in the process.
Determining if Chapter 13 is the appropriate decision.
Chapter 13 bankruptcy provides an opportunity to catch up on payments and retain property, which may be beneficial for individuals with non-dischargeable priority debt or those who have fallen behind on mortgage or car loans. The repayment plan helps to consolidate debt.
Which Option is Worse from a Mortgage Standpoint?
From a mortgage lender’s perspective (which happens to be my background), this is how we look at the differences between Chapter 7 and Chapter 13 bankruptcies.
Chapter 7 (& Chapter 11 for businesses): There is a 4-year waiting period after the discharge in order to get mortgage financing. There’s a two-year waiting period if extenuating circumstances can be documented, and is measured from the discharge or dismissal date of the bankruptcy action.
Chapter 13: There is a 2-year waiting period after the discharge of Chapter 13 however, keep in mind that the course of this reorganization of debt can take 3 to 5 years. If the case was dismissed, meaning the process was not completed, and thus not discharged, it would be 4 years after that dismissal date.
Just like with Chapter 7, there’s a two-year waiting period if extenuating circumstances can be documented, and it is also measured from the dismissal date of the bankruptcy action. Extenuating circumstances do not shorten the 2-year waiting period after the discharge date of Chapter 13.
With that said, you should know that you can still refinance with an FHA loan after just 12 months into the Chapter 13 as long as it’s approved by the bankruptcy court, thus it must make sound financial sense.
The aforementioned guidelines are based on FNMA’s (Fannie Mae) position on the topic. FHA and VA financing guidelines are slightly different from FNMA.
With FHA or VA financing, there is a two-year waiting period (instead of 4-year with FNMA) after the discharge of a Chapter 7 bankruptcy. This can be reduced to one year for extenuating circumstances. For Chapter 13, there is a one-year waiting period from the date of the discharge date and you must get written permission from the court to incur the new debt. I’ve helped consumers with many of these. Typically, if we’re improving the borrower’s cash flow and/or removal of remaining debt, the court will approve the action.
Extenuating Circumstances?
You may be wondering what constitutes, “extenuating circumstances”. Each case is different but generally an extenuating circumstance is something that is out of your control. This could be a natural disaster, a serious illness, the death of the main income earner, a job lay-off, a prolonged strike, or more than a 20% reduction of income over a 6-month (or more) period of time. It should be noted that a divorce is not considered an extenuating circumstance.
Rebounding From a Chapter 7 or Chapter 13 Bankruptcy
Just sitting idle during the waiting periods (as described herein) is not a strategy. To rebuild your credit and prove to a future lender that you are creditworthy, you need to put in the work. A good way to start the rebuilding process is with Secured Credit Cards. These are Visa or MasterCard credit cards issued by your local banks or credit unions. The “credit limit” on these cards (usually around $500) is based on the amount of funds that you place into an account with that bank/credit union as collateral. See more tips here.
Seek Legal Expertise
The suggestions made within this article are based on my own experiences with past clients and independent research only. I am not an attorney. You should do your own research.
To receive guidance on your unique circumstances and objectives regarding bankruptcy, it is advisable to seek consultation from a bankruptcy attorney. Their expertise will assist in determining your eligibility and the appropriate chapter for your case.
The choice between Chapter 7 and Chapter 13 bankruptcy is determined by financial circumstances and goals. It is important to understand the advantages, disadvantages, and eligibility requirements of each in order to make an informed decision. With professional legal assistance, the best debt relief option can be determined.
