Here’s the Difference between Chapter 7 and Chapter 13 Bankruptcy

“It is said that the world is in a state of bankruptcy; that the world owes the world more than the world can pay ...” – Ralph Waldo Emerson

Chapter 13 bankruptcy originally arose from the need to look out for wage earners, and to this day, what differentiates it most from Chapter 7 is the idea that as long as regular efforts are made to get out of debt, property can be kept and wages can be free of garnishment.

This blog post explains some of the differences between Chapter 7 and Chapter 13. It provides some takeaways about the economics of bankruptcy, as well. (This information is not to be taken as legal advice.)

Why would someone choose Chapter 13 over Chapter 7? One reason may be that under Chapter 13, the list of debts eligible for discharge is more expansive.

At a Glance: Chapter 7 vs. Chapter 13 Bankruptcy

Chapter 7 bankruptcy is known as liquidation, as it involves liquidating assets to pay off creditors. A trustee is assigned to take charge of the debtor’s eligible property.

Depending on federal exemption provisions and the state you live in, some assets may be exempt from liquidation; this could include personal items and possibly real estate. The United States Courts notes that an individual debtor can choose between a federal package of exemptions or the exemptions available under his or her state’s law.

After non-exempt assets are distributed to creditors, the remaining eligible debt is discharged, which means the debtor doesn’t have to repay it. Creditors can no longer take action to collect debt that has been legally discharged.

Certain debts, however, cannot be discharged. These include most taxes, student loans, court fines, child support, alimony, and debts arising from drunken or drug-influenced driving.

Chapter 13 involves reorganization and repayment. In order to be eligible, you must earn a regular income. An individual debtor will participate in a three- to five-year plan to make installment payments to creditors.

In most cases, you can keep your property under Chapter 13. The U.S. Courts notes that people may use a Chapter 13 proceeding to save their homes from foreclosure.

The trustee’s role in Chapter 13 is to serve as an impartial intermediary, collecting payments from the debtor and distributing them to creditors. The remainder of other debts, such as credit card debts, are discharged.

Recent Trends in Chapter 7 and Chapter 13 Filings

Historically, Chapter 7 filings have occupied a larger percentage of total nonbusiness bankruptcy filings than Chapter 13. U.S. Courts data show that between 2005 and 2017, approximately 12.8 million consumer bankruptcy petitions were filed in federal courts. Of these, 68% were Chapter 7, while only 32% were Chapter 13.

Annual bankruptcy filings increased during the 2007-09 recession, reaching their highest point in 2010.

Since 2010, Chapter 7 filings as a percentage of total filings have decreased, while Chapter 13 filings have risen as a percentage of total filings. Interestingly, Southern states have a higher concentration of Chapter 13 bankruptcy filings per thousand than the rest of the nation. However, Chapter 7 still remains more common nationwide.

Why Would Someone Choose Chapter 13 over Chapter 7?

First, under Chapter 13, the list of debts eligible for discharge is more expansive than under Chapter 7. This includes debts arising from willful and malicious injury to property and debts from divorce property settlements.

Retired bankruptcy court attorney adviser Shaun K. Stuart has some other possible explanations. Stuart assisted with the St. Louis Fed’s Page One Economics essay, Bankruptcy: When All Else Fails, published in April 2018.

Stuart noted that:

• Chapter 13 allows you to reschedule certain debts to be spread out over a longer period of time, which could lead to smaller, more manageable payments.
• If you are behind on your mortgage, you can keep your home and prevent foreclosure, as long as you keep making payments. 
• Furthermore, you have more time to pay back debts that can’t be discharged under Chapter 7 (up to five years).
• Chapter 13 can also protect third parties who are liable with the debtor on consumer debts. For example, if a payment plan is completed, co-signers are protected from creditor action.
• You can assign debts with co-debtors to different payment percentages and creditor classes than debts incurred by yourself. 

Lastly, Stuart said, you can pay attorney fees through the Chapter 13 plan, and file a Chapter 13 more than once if needed.

The Economics of Bankruptcy

Consumption

From an economics standpoint, bankruptcy might be considered a process whereby inefficient businesses are driven out of the market by the forces of competition.

For individuals who find themselves in financial trouble, the concepts of incentives and insurance are at play, too.

In a shorter version of a National Bureau of Economic Research working paper, University of California-San Diego economics professor Michelle J. White notes that personal bankruptcy provides a sort of “consumption insurance.”White, Michelle J. “Bankruptcy law, economics of corporate and personal. (PDF) ” The New Palgrave Dictionary of Economics, 2nd edition. 2008.

This is the idea that discharging certain debts gives individuals a greater ability to spend money that otherwise would have been used to repay those debts. So, someone filing for bankruptcy in the event of a job loss, for instance, would not have to cut back as dramatically on consumption of goods and services.

She explains that the financial benefit of bankruptcy equals any debts that don’t have to be paid back, minus the sum of assets used to repay creditors. The author writes that households tend to file for bankruptcy more when the financial benefit from filing rises. As exemptions increase, the amount of “consumption insurance” also increases.

Financial Well-being

A National Bureau of Economic Research working paper analyzed the effect of declaring Chapter 13 bankruptcy on the financial well-being of U.S. households.Dobbie, Will; Goldsmith-Pinkham, Paul; and Yang, Crystal S. March 2015. “Consumer Bankruptcy and Financial Health.” National Bureau of Economic Research Working Paper No. 21032.

The authors found that over the first five post-filing years, Chapter 13 protection decreases an index measuring negative financial events, such as repossessions and civil judgments. Further, they said Chapter 13 protection increases credit scores, the ability to attain credit and the likelihood of owning a home.

Using a dataset that linked bankruptcy filings to credit bureau records, the authors said that Chapter 13 protection had little impact on unsecured debt, but that it reduced the amount of debt in collections by $1,315.

Notes and References

¹ White, Michelle J. “Bankruptcy law, economics of corporate and personal.” The New Palgrave Dictionary of Economics, 2nd edition. 2008.

² Dobbie, Will; Goldsmith-Pinkham, Paul; and Yang, Crystal S. March 2015. “Consumer Bankruptcy and Financial Health.” National Bureau of Economic Research Working Paper No. 21032.

Additional Resources

The U.S. Courts offers an excellent bankruptcy primer for consumers. Meanwhile, our Economic Education team has a Bankruptcy Basics lesson that teachers can use in their classrooms.