A Rule of Thumb about Choosing between Chapter 7 and Chapter 13

If you qualify for both, first find out whether and how much you’d be helped by Chapter 13, then decide whether Chapter 7 is enough.

The Choice is Unique for Each Person

The main point of my last blog post was that Chapter 7 and 13 each have their advantages and disadvantages. Some of those may not be obvious. So it’s important to be open-minded when you meet with your attorney to find out about your options.

Let’s assume you qualify for both Chapter 7 and Chapter 13. Then the choice really depends on your personal, unique combination of circumstances, and on your personal goals.

The “Rule”

However, the following broad rule of thumb may help you start thinking about the choice constructively:

File a Chapter 7 “straight bankruptcy” unless the many extra tools provided by Chapter 13 “adjustment of debts” makes that worthwhile for you instead.

Solve Your Problems

This does not mean that you file under the usually simpler Chapter 7 whenever you qualify to do so. Your goal is not necessarily the simplest bankruptcy. Your goal is a better financial life, and using the right legal tool to get there.

Two Big Truths

The rule of thumb above rises out of two big truths about Chapter 7 and Chapter 13:

1. Although Chapter 7 is usually much simpler than Chapter 13—faster and cheaper,

2. Chapter 13 comes with many potentially very helpful features that are not available under Chapter 7.

Two examples will show how this works.

A Chapter 7 Hypothetical

Imagine that a husband and wife own a home they want to keep. They have fallen behind on the mortgage by three $1,400 payments, totaling $4,200, because one of them was unemployed for several months.

Now that they are both working again they believe that if they filed a Chapter 7 case to discharge all their other debts, they could put all their effort into paying off that $4,200 mortgage arrearage by paying $420 extra each month for the 10 months or so until they were caught up. Their attorney informs them that their particular mortgage lender has accepted similar terms with other homeowners, and the couple is willing to accept the risks involved. Their budget would be tight during those 10 months but livable, so they are confident that they could realistically do it.

So Chapter 7 seems like a sensible option here.

A Chapter 13 Hypothetical

Now take the same situation with two twists. First, instead of 3 months behind the couple is 6 months behind–$8,400—on their first mortgage. Second, they have a second mortgage on which they owe $30,000. Also, the home is worth no more than the balance on the first mortgage.

Assuming that, as in the above Chapter 7 example, they could only afford about $420 per month towards the mortgage arrearage catch-up payments, it’s much less likely that their lender would allow them the 20 months or so to bring the mortgage current after filing a Chapter 7 case.

However, if they filed a Chapter 13 case instead, they could stretch out these catch-up payments over a period of three to five years, reducing the amount to be paid each month to a much lower and sustainable amount. Plus throughout this time they would be under the protection of the bankruptcy court preventing a foreclosure or any other collection activity as long as the couple did as their Chapter 13 payment plan required. And if their circumstances changed, their payment plan could likely be amended to adjust to those changes.

Furthermore, under Chapter 13 (but not Chapter 7), the couple would likely be able to “strip” the second lien off the home’s title, meaning that they would likely avoid paying all or most of that $30,000 balance (together with many thousands of dollars of future interest). This would get them that much closer to building equity in their home.

In this second situation, Chapter 13 makes a lot more sense, being less risky and likely saving them much more money.

Summary

In this second example, Chapter 13 provided some tools—stretching out the arrearage payments and “stripping” the second mortgage–that would enable this couple to save their home while saving a lot of money. In the first example, those tools either were not needed or didn’t apply, so Chapter 7 was the better solution.