The conversation typically starts with something like “my friend filed chapter 7 bankruptcy and wiped out a ton of debt without paying anything!” Or, “I read online that a chapter 7 is better, so that’s what I want to file.” It’s true that filing a Chapter 7 bankruptcy case is a great way to get a financial fresh start, but Chapter 7 is not one-size-fits-all, and may not be right for you.
First a brief (and oversimplified) look at chapter 7 vs. 13. Typically, the purpose of filing a Chapter 7 case is to eliminate (“discharge”) unsecured debt (like credit cards and medical bills). It is most appropriate for individuals who have a lot of unsecured debt, expenses greater than their monthly income, and no assets they could liquidate to pay their debt. Chapter 13 is more multi-purpose and is tynpically used to allow the filer to catch up on delinquent secured debt (like a mortgage or car loan), and/or to repay a portion of his/her unsecured debt. A chapter 7 case typically takes around 4 months from start to finish, while a chapter 13 takes 36-60 months.
With a Chapter 7 taking less than one-tenth the time of a chapter 13, and wiping out debt without requiring any of it to be paid back, it’s no wonder people want to file under Chapter 7. But for many people, a Chapter 13 bankruptcy is the better (and sometimes only) option. Here are the 4 main reasons why you may not be able to file a Chapter 7 bankruptcy (or don’t really want to even if you could):
1. Timing of a prior case. This one is easy – just some basic math. You can’t get a Chapter 7 discharge if you filed a prior Chapter 7 case within the past 8 years. You also can’t get a chapter 7 discharge if you received a discharge in a Chapter 13 case filed within the past 6 years. The idea here is to prevent people from repeatedly running up debt that they don’t pay. Think of this as the “it’s just not fair to the creditors” bar to Chapter 7.
2. Too much income. Most people laugh (or at least chuckle, or become wide-eyed with shock and disbelief) when they hear that they have too much income to file a Chapter 7. But it’s true – you may feel like you’re broke but still have too much income to file a Chapter 7. You might even have more bills each month than you have money coming in, but still have too much income to file a Chapter 7.
It’s not all about income in vs. expenses out – the amount of some expenses is capped by bankruptcy or IRS rules (like food, clothing, and personal care), and some expenses can be considered unreasonable (like one person who has two or more financed vehicles). There’s also something called the means test – a mind-bending analysis of your income and expenses designed to determine if your income is higher than the median income in your state and, if it is, how much disposable income you “should” have at the end of each month to pay your creditors. The bottom line is that after subtracting your expenses from your income, if there’s “extra” money left over, that’s considered disposable income that can be used to pay your unsecured debt. Which means you can’t file a Chapter 7. Think of this as the “I guess I don’t really need two cars and the $300 a month cable TV package” reason why you can’t file a Chapter 7.
3. Debt is secured / trying to save an asset. This is probably the most common reason why someone has to file a Chapter 13 instead of a Chapter 7 bankruptcy. If you are behind on any secured debt (mortgage payments, car payments, etc.), filing a Chapter 7 case will temporarily stop any foreclosure or other collection action, but a Chapter 7 case doesn’t provide a way to fix the problem. As soon as your Chapter 7 case is done (or sometimes sooner) foreclosure and other collection efforts pick up right where they left off.
On the other hand, Chapter 13 provides an opportunity to catch up on delinquent mortgage or car payments over a period of three to five years. Any foreclosure or other action to take your property stops immediately when the case is filed, and the creditor can’t resume foreclosure (or any other collection effort) without first getting court approval. A Chapter 13 case also gives you time to apply for a loan modification or sell or refinance property if appropriate in your situation. Whatever you and your bankruptcy attorney decide is best for you, a Chapter 13 gives you the breathing space to move forward without the specter of a looming foreclosure action. Let’s call this the “it feels so good to finally exhale” reason why you don’t want to file a Chapter 7.
4. Excess Equity. The bankruptcy laws are designed in large part to protect debtors, but the laws are designed to protect creditors as well. One of the ways the bankruptcy code balances these competing interests is through exemptions. Basically, a debtor gets to have stuff (a home, a car, clothing, even jewelry) that (s)he gets to keep without fear of having to sell the stuff to repay creditors. But the debtor only gets to keep stuff worth up to a certain value – after that, the value of the stuff has to be shared with creditors. The max value that a debtor gets to keep before (s)he has to share with creditors is called an exemption. Ugh – confusing. Let’s try an example: say I have a car that’s fully paid for, and it’s worth $4,000. In NJ, the maximum exemption for a motor vehicle is $4,450. Since the car is worth $4,000, and I own the car outright, I have $4,000 in equity in the car. And since I’m allowed to have up to $4,450 in equity, I get to keep my car and I don’t have to share any of its value with my creditors. Now let’s say the car is worth $15,000. In that case I would have $15,000 in equity in the car, but I’m only allowed to have $4,450. So I have $10,550 of “non-exempt” equity – and that means I have to share $10,550 with my creditors.
Here comes the 7 vs 13 part: if you have non-exempt equity in any of your stuff and you file under Chapter 7, the trustee can sell your stuff in order to turn your stuff into actual money that can be shared with your creditors. If you file under Chapter 13, instead of selling your stuff, you will be allowed to keep it and pay the non-exempt portion over the 3 to 5 years of your case. Let’s call this the “but I really need my stuff” reason why you probably don’t want to file a Chapter 7.
As you can see, it’s not always best to file a Chapter 7 bankruptcy case. Ultimately, you and your bankruptcy attorney will figure out the best way for you to proceed based on your specific financial circumstances. No matter which type of bankruptcy case you ultimately pursue, filing bankruptcy is a great way to take control of your finances and move forward. Let’s call this the “I’m so happy I contacted a bankruptcy attorney and got a financial fresh start” result you deserve.
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