If you have excessive consumer debt and are considering filing for protection, it's essential you understand your options. Filing bankruptcy requires a lot more deliberation than just acknowledging you’re drowning in credit card debt.
One of the most significant decisions is whether to file for Chapter 7 or Chapter 13. Both types of bankruptcy remain on your credit history for 10 years, but they can each have a unique effect on your financial health (or lack there of). In simple terms, “under Chapter 7 your assets are sold to pay off your debts and the remaining debt is discharged,” says Michael Eisenberg, spokesperson for the American Institute of Certified Public Accountants. In other words your slate is wiped clean. “Under Chapter 13, you’re not required to sell assets, but you can rearrange your debt based on your income and pay it off in three to five years.” Meaning less debt is forgiven, but that you also get to keep more of your stuff.
Reorganizing your debt under Chapter 13 can be extremely effective in dealing with debts that won’t be handled under Chapter 7, says bankruptcy attorney Leon Bayer, a partner at Bayer, Wishman & Leotta based in Los Angeles. Tax debt, for example, isn’t relieved through Chapter 7. It can also help someone who might have significant debt, but can also afford day to day expenses. For example, say a person loses his job and falls behind on mortgage payments. Even if he finds new employment, if delinquent mortgage payments aren’t repaid, the bank will foreclose. “Filing of Chapter 13 will stop the foreclosure and put a homeowner back on a payment schedule that requires paying regular payments again to prevent getting further behind,” says Bayer. “Each month you pay something extra to catch back up again. You’ll walk gradually forward to get yourself out of this.”
You can rearrange payments under Chapter 13 to be paid over the course of as many as 60 months. In many cases if you can afford to catch up on your house payments, but can’t pay credit cards, your credit card debt is then discharged just as in a Chapter 7. “Chapter 13 takes elements of Chapter 7 and incorporates them to help someone come up with a tailor made reorganization based upon paying their best good faith effort,” says Bayer. Many people want to file under Chapter 13 because they feel obligated to help pay off their debt. But it’s not always the best solution, and often Chapter 7 is a better remedy.
“Most Chapter 7 debtors today are primarily concerned with credit card debts,” says Bayer. “It is not uncommon to see Chapter 7 cases for individuals that have credit card debts exceeding their annual income, sometimes double or even triple what their annual income may happen to be. For such an individual, Chapter 7 holds out the promise of gaining relief from those debts.”
But because Chapter 7 forgives most debts, it’s significantly more difficult to qualify. “There’s an income rule based on your state and if you’re capable of repaying a portion of your debt you’re forced to file Chapter 13,” says Eisenberg. Part of what makes filing Chapter 7 so difficult is that you need to meet a federal “means test.” The test requires you to provide “detailed financial information including a list of all debts, a list of all assets, a list of current living expenses, a schedule of current and projected income, as well as the answers to many questions that delve into a person’s financial affairs over the last several years,” says Bayer. This is one test where bluffing gets you nowhere. The IRS pays close attention to all answers.