When individuals fall behind on bills and need protection from creditors, they usually do so using the Chapter 7 form of bankruptcy. The primary advantage of a Chapter 7 filing is that you can essentially wipe your financial slate clean without worrying about “past due” amounts. Once a trustee liquidates your saleable assets and pays your creditors, lenders ordinarily can’t call you in an effort to collect.

However, there’s another avenue struggling borrowers can pursue: Chapter 13 bankruptcy. It’s a form of debt reorganization in which individuals develop a plan to repay as much of their debt as possible over a three-to-five-year period. The bankruptcy court requires them to provide detailed financial statements to show their revenue and expenses; they then make an agreed-upon monthly payment to a trustee, who in turns pays their creditors.

Once a Chapter 13 repayment plan is completed, you are no longer responsible for your previous debts, even if you didn’t pay the entire amount you originally owed. It also stops the interest-rate clock from increasing, for example, the amount you owe on your credit card debt. Just keep in mind that certain types of debt – including student loans, alimony and child support – cannot be discharged under either type of bankruptcy, Chapter 7 or Chapter 13. 

Pros and Cons

Perhaps the most compelling reason to opt for Chapter 13 protection over Chapter 7 is to save your home. If you’re behind on your mortgage, only Chapter 13, also known as a “wage earner’s plan,” allows you to make up missed payments and eventually become current on the loan.

Losing your home isn't inevitable if you file for bankruptcy under Chapter 7. If you’re current on your mortgage and have little or no equity in the property, you’re usually safe. The trustee won’t be able to make much money off the sale of your home to pay other creditors, so there’s no incentive to put it on the market. However, if you exceed the allowable equity, or homestead exemption, in your state, Chapter 13 can start to look more attractive. A qualified bankruptcy attorney will be able to advise you on how your home would be affected by either option.

Additionally, you may want to consider Chapter 13 if:

  • you have a co-signer on a loan and want them to have some protection from creditors,
  • you’re underwater on your first mortgage and want to use Chapter 13 bankruptcy to eliminate any junior liens on your home,
  • you can’t file under Chapter 7 because you got a Chapter 7 bankruptcy discharge within the past eight years,
  • you can’t use Chapter 7 because you can afford to pay back some of your debt and therefore fail the means test.

One of the major drawbacks is that paying for past debts on top of one’s current obligations can be a stressful proposition. According to researchers, only about one-third of all filers complete their repayment plan and see their debt discharged. Unless there’s a strong reason to choose Chapter 13 over another form of bankruptcy, this low success rate might convince you to take a hard look at Chapter 7.   

Who Can File

Chapter 13 protection is intended for individuals and married couples, even if the borrower is self-employed. However, the U.S. Bankruptcy Code does put some restrictions on who can file. An individual’s unsecured and secured debts cannot exceed a certain amount (currently $383,175 and $1,149,525, respectively). Because the debtor or debtors must follow a repayment plan, they also have to have a steady form of income to qualify.

If the filer meets these requirements, he or she must receive credit counseling through an approved agency prior to filing for bankruptcy.

The Bottom Line

Choosing between Chapter 13 and Chapter 7 bankruptcy is an important undertaking, with significant repercussions. To ensure that your attorney gives you the best advice, be sure to provide accurate information about your finances and alert him or her to any special considerations that may affect your decision. For more information, check out Investopedia's library of Personal Bankruptcy articles.

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