Chapter 7 and Chapter 13 Bankruptcy — Comparison of Benefits and Drawbacks

Key Background Articles:

Key Facts:

For most individual debtors, the main choices in bankruptcy are between Chapter 7 and Chapter 13. This choice has been limited by the new means test that was enacted by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), but, in many cases, the debtor will still have a choice, depending on his income.

Brief Overview of Chapter 7 and Chapter 13

When a Chapter 7 petitioner files, all of the debtor's property becomes part of the bankruptcy estate from which the trustee will sell certain assets, if any, and pay the proceeds to the debtor's unsecured creditors. Assets that are claimed as exemptions are withdrawn from the bankruptcy estate, as well as property that is abandoned by the trustee because it either has too little value or security interests on the property limit the net proceeds after a sale to pay unsecured creditors. Since most Chapter 7 filers have no valuable, unencumbered assets, the Chapter 7 debtor sacrifices little, if anything. More importantly, all income earned after the filing date belongs to the debtor. This income is used to establish a fresh start for the debtor, which is one of the main goals of bankruptcy.

By contrast, a Chapter 13 petitioner must pay all projected disposable income over 3 or 5 years either to secured creditors and lessors of property, or to the Chapter 13 standing trustee, who then distributes the payments to the debtor's unsecured creditors. The Chapter 13 petitioner submits a payment plan for confirmation by the court, and if approved, must complete the plan before receiving a discharge.

Benefits of Chapter 7 Over Chapter 13

The main benefit of Chapter 7 over Chapter 13 is that a Chapter 7 petitioner receives a discharge 4 to 6 months after filing for bankruptcy, whereas a Chapter 13 petitioner must make payments to creditors for either 3 or 5 years, depending on the debtor's income, before she can receive a discharge.

A consequence of the short time period of a Chapter 7 bankruptcy is that the Chapter 7 debtor can establish new credit much sooner than a Chapter 13 debtor even though a Chapter 7 bankruptcy stays on credit reports for 10 years from the date of filing, while a Chapter 13 bankruptcy can only be listed for 7 years. The Congressional view is that Chapter 13 is a more responsible choice that will give the debtor a better credit profile than a Chapter 7 petitioner, but this view does not comport with how the creditworthiness of individuals is actually assessed.

The most common way to assess an individual's creditworthiness is by getting their credit score, which is calculated according to a specific algorithm based on information in one's credit files held by credit reporting agencies. Most credit scores, including the commonly used FICO scores, depend mostly on the last 2 years of one's credit behavior, including one's record of paying bills on time and not incurring too much debt compared to the amount of credit available (credit utilization). More weight is given to more recent data.

Hence, a Chapter 7 bankrupt could quickly re-establish credit by paying bills on time and avoiding too much debt. Furthermore, he would be perceived as a better credit risk because most of his unsecured credit debts would be wiped out by the discharge and he would be prevented from receiving another Chapter 7 discharge for 8 years.

By contrast, a Chapter 13 debtor would have difficulty obtaining any new credit until she received her discharge 3 or 5 years after filing.

Bankrupt Profits: The Credit Industry's Business Model For Postbankruptcy Lending, Katherine Porter, College of Law, University of Iowa - This study by a bankruptcy professor shows that a Chapter 7 bankrupt can obtain credit more easily and much sooner than a Chapter 13 bankrupt. In fact, specific lenders target bankrupts because their re-filing options are limited, most of their debt is discharged, and they are willing to pay much higher interest rates and other fees to get credit.

Benefits of Chapter 13 over Chapter 7

The main benefit of Chapter 13 over Chapter 7 is that the debtor will be able to keep valuable property that would otherwise be sold under Chapter 7 to pay unsecured creditors. A Chapter 7 debtor could only keep unsecured nonexempt property by paying the trustee the cash value of the property, or, if the property is secured, then the debtor would either have to redeem the property by paying the full amount of its value as a lump sum or he would have to sign a Reaffirmation Agreement in which he would have to continue making payments for the full amount of the debt in spite of the bankruptcy.

Cramdowns. By contrast, the Chapter 13 debtor can keep all of her property by paying according to her Chapter 13 payment plan. If confirmed by the court, then the creditors must accept the plan. Furthermore, the Chapter 13 debtor can cure any arrearages over time and reverse any acceleration of loans, at least until the foreclosure sale. And for property other than mortgages, motor vehicles purchased within 910 days, or other property purchased within 1 year of the bankruptcy filing date, the debtor may be able cram down the loan by paying only the value of the collateral over time rather than the full amount of the debt, and usually at a lower interest rate than the contract rate.

Creditor classification. If permitted by the court, the debtor may be able to classify her creditors into different classes that are paid differing amounts. This may allow her to group priority claimants, who have to be paid the full amount of their debt, into a group that will receive 100% of their claims while another group of unsecured, non-priority claimants may only be paid a fraction of their claims.

Co-debtor stay. The automatic stay under Chapter 13, unlike Chapter 7, extends to co-debtors who have guaranteed the loan for the debtor. However, this extension of the automatic stay only applies to consumer debts where the petitioner received the benefits of the loan.

A Chapter 13 petitioner who successfully completes her payment plan will receive a so-called super-discharge, which discharges some debts that are not discharged under Chapter 7. However, the super-discharge has been greatly reduced in its scope by the BAPCPA. Now it only includes taxes due more than 3 years before the filing date, debts arising from a divorce or separation agreement, and fines and penalties that do not compensate for a pecuniary loss suffered by another.

While there are many grounds for denying a discharge to a Chapter 7 petitioner, a discharge for a Chapter 13 debtor will only be denied for nonperformance or because the debtor did not take the required debtor education class.

A Chapter 13 debtor who pays 100% of allowed claims or at least 70% as a best effort will not be prevented from receiving a Chapter 7 discharge in a later bankruptcy filing; otherwise there will be a 6-year bar to receiving a discharge under Chapter 7 in contrast to a 8-year bar for the Chapter 7 petitioner.