Clark Howard

What's the difference between Chapter 7 and Chapter 13 bankruptcy?

When it comes to money matters, most of us have experienced financial setbacks at one time or another. The great thing is that if we come up with a plan, we can usually dig ourselves out of debt. But if we can’t, one of the most effective ways of ridding ourselves of crushing debt is through bankruptcy.

There are several types of bankruptcies available to debtors. Typically, individuals file Chapter 7 or Chapter 13 bankruptcy (Chapter 12 is generally reserved for farmers and fishermen while Chapter 11 is usually for businesses). But you may be wondering what the differences are between Chapters 7 and 13 bankruptcy.

While we've previously discussed filing for Chapter 7 and Chapter 13 respectively. Here we're going to look at key ways to decide whether Chapter 7 or 13 is best for you and the benefits and drawbacks of each.

The difference between Chapter 7 and Chapter 13 bankruptcy

“Each Chapter has its own advantages and disadvantages,” longtime bankruptcy attorney Bernd Stittleburg of Duluth, Georgia, tells Team Clark. “The main difference between Chapter 7 and Chapter 13 is that a Chapter 7 will allow the debtor to eliminate all dischargeable unsecured debt, whereas the Chapter 13 would allow for payments to be made on those debts.”

You may have other questions about these two bankruptcy filings as well, such as why is bankruptcy broken up into chapters anyway? And why does bankruptcy, a legal means of getting out of debt, have such a stigma attached to it? Here are some answers.

Should you file for Chapter 7 or Chapter 13?

To decide whether Chapter 7 or Chapter 13 bankruptcy is right for you, the first thing you should do is scrutinize the particular reason you’re in debt.

“Which one a debtor will use really depends on what the major debt problem is at the time he or she decides to file,” Stittleburg said.

Choosing whether Chapter 7 bankruptcy is for you

Chapter 7 bankruptcy is characterized by the debtor’s claim that he or she is financially destitute — you typically don’t have gainful employment that would allow you to earn money to pay down your debts. Chapter 7 in this sense is a liquidation bankruptcy.

Because the debtor is insolvent, a trustee will usually be appointed to handle your case, including selling your assets so that your creditors get something. In many cases, though, the creditors may end up with nothing.

“The prime candidate for a Chapter 7 case would be one who has recently lost a job, has no income or even if still employed, does not have enough income to pay all of his or her debts,” Stittleburg said. “Usually in these circumstances, the debtor has too much debt for the amount of money he or she is bringing into the household. Filing a Chapter 7 case in this situation would allow the debtor to eliminate debt and have a chance to recover and rebuild.”

Choosing whether Chapter 13 is for you

If you meet certain conditions, the law allows you to convert your Chapter 7 bankruptcy into a Chapter 13 bankruptcy, Detroit, Michigan-based bankruptcy lawyer Kurt O'Keefe tells Team Clark. "Of course, there has to be some money left in your budget of future projected income and expenses to fund your plan," he says.

“Your plan payment is the difference between your projected income and expenses. That also must be enough to pay your creditors at least what they would get in a Chapter 7.”

With a typical Chapter 13 case, you will be allowed to keep your personal property, but you must be able to work to pay off your creditors. So a key factor in choosing Chapter 13 is whether you can earn wages or not. Your repayment plan and budget must be approved by the court and a trustee will be appointed to collect payments from you.

So choosing to file for Chapter 13 doesn’t mean you’re impoverished so much as it means that you just can’t pay your bills as your creditors require.

"Over the number of years that I have practiced in the bankruptcy area, I have found one of the major reasons a debtor will file a Chapter 13 is because he or she is in arrears on payments of automobiles and/or homes. This type of bankruptcy will allow the debtor to formulate a plan that will bring one or both of these types of debts back to a current status."

Which debts can be discharged in a bankruptcy?

Another reason many people file for bankruptcy is to have their debts "discharged," which is a court order that states that you do not have to repay what you owe. This could wipe out a number of credit card bills and even a car note, but the Department of Justice says the following debts cannot be discharged:

  • most taxes
  • child support
  • alimony
  • most student loans
  • court fines and criminal restitution
  • personal injury caused by driving drunk or under the influence of drugs

When will Chapter 7 or Chapter 13 bankruptcy be removed from your credit report?

A Chapter 7 bankruptcy will stay on your credit report for 10 years, while a Chapter 13 bankruptcy will stay on your credit report for seven years. The good thing? You don't have to do anything to remove them from your credit file. Once the time has elapsed, bankruptcies will automatically disappear from your credit report, according to Credit Karma.

Now that you know the difference between Chapters 7 and 13, make sure you’re not viewing bankruptcy as a first resort. Money expert Clark Howard says that people often make that mistake when they’re struggling to pay bills.

"Often I find that people file for bankruptcy when they've had one too many calls from the debt collector," Clark says. "But that's not the reason to file." Here's the reason a person should declare bankruptcy, according to Clark.

The origins of bankruptcy

The word bankruptcy is a 16th century phrase that derives from the Italian term banca rotta, which literally means "broken bench," or "broken bank," according to the Oxford Dictionary.

In the ancient world, there was no such thing as bankruptcy. If you owed a debt and couldn't pay, more likely than not, you were forced into a form of slavery tied to your debt. In 19th century Europe, "debtor prisons" became a common place to lock people who couldn't pay their debts up.

As the rule of law began to evolve and become more humane, prison terms linked to indigence began to lessen. In the United States today, there are only two ways a person who owes money can be imprisoned for circumstances linked directly to debt.

In many cases, a person can be legally incarcerated for failing to appear in court in a debt-related case. But again, that’s not directly because of the debt per se, but rather contempt of court.

Interestingly, Protocol 4 of the European Convention on Human Rights outlaws imprisonment for breach of contract. But several European nations have either failed to sign or ratify the measure.

As for the way debts were handled in centuries past, in some cases debtors were allowed to get rid of their debt by selling it. In 1813, Parliament passed the Insolvent Debtors Act under England’s King George III.

The act was designed to relieve many debtors of incarceration, thereby easing the pressures on the prison system. It still left the creditor with tremendous power over the debtor and only reduced the length of time an insolvent person could be imprisoned.

Of course, going into financial ruin came with significant scrutiny back then. Impoverished people were seen as part of a permanent peasant class that would perennially stay at society’s bottom rung.

The road to modern bankruptcy law

Mirroring Europe's evolution, the United States also arrived at the belief that debtors deserved better. Spurred on in part by the Panic of 1837 in which thousands of people lost their financial means, a series of bankruptcy acts in 1838, 1841 and 1867 gave everyday debtors certain rights and protections that merchants and traders already enjoyed.

While each measure only lasted a handful of years before being improved upon, the legislation absolved thousands of people of their debt and set the stage for greater reform.

Uniformity didn't come until years later when Congress passed the 1898 Bankruptcy Act. This piece of landmark legislation appointed an official referee to handle bankruptcy cases. The law remained in place until 1978. That's when the Bankruptcy Reform Act, which established among other key changes the U.S. Trustee Program, was passed into law.

That era was seen as a precipitous time for the American consumer. Personal bankruptcies had skyrocketed between the late 1970s and early '80s and the average debtor in bankruptcy owed around $34,000 but had only repaid about $200, according to an University of Indiana law school paper written by current University of California-San Diego Economics professor Michelle J. White.

White said that a slate of business failings also contributed to a climate of higher interest rates and made lenders coy about trusting borrowers.

In addition to establishing bankruptcy courts in each district, the 1978 legislation also replaced the old-world practice of using Roman numerals for chapters X, XI and XII and introduced Chapters 11 (typically for businesses) and 13 (for individuals). For Chapter 7, the new bankruptcy code also gave borrowers a “super” discharge of all debts, in many cases without any payment.

In 1986, the U.S. Trustee Program, run by the Department of Justice, was rolled out across the nation, except in North Carolina and Alabama, where administrators programs served the same role.

Bankruptcy law continued to evolve in 2005 with passage of the Bankruptcy Abuse and Consumer Protection Act, which got rid of the "super discharge" provision for Chapter 13. The measure also mandated that some debtors undergo financial management training and credit counseling as a condition of debt relief.

RELATED: Your guide to paying off credit card debt

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