Hidden Advantages of Chapter 13 Bankruptcy
If you ask the average person to describe bankruptcy, they would probably say, “You file some paperwork, your debt is eliminated, and your credit is destroyed. But at least you don’t owe any more money.”
That’s not too far from the truth, at least for some filers. The common perception of bankruptcy is what we call a Chapter 7 filing — the type of bankruptcy where debt is eliminated. However, many people cannot or will not file under Chapter 7, and instead choose a different type of bankruptcy: Chapter 13. Under Chapter 13, your debt is reorganized as part of a payment plan, which allows you to catch up on your debt over time, rather than eliminate it. There are some major advantages to the Chapter 13 filing: you no longer have to pass a means test that requires you to be lower income, and you get to keep your assets rather than have many of your treasured possessions stripped away and sold off to pay your debt, as happens under the debt-eliminating Chapter 7.
And if filing bankruptcy but not eliminating your debt sounds like a bad deal, here is a bonus tactic that is not very well-known but is a part of Chapter 13 filings that may sway you to take the repayment plan: you can eliminate some significant debt, especially if you are underwater (owe more than the property is worth) on your mortgage or your car loan, through a process called a “cram down.”
Make Sure You Know All of Your Options Before You File for Bankruptcy
The biggest problem with do-it-yourself bankruptcy services or online providers is that they may not take the time to explain all of your options in a bankruptcy case. And while mandatory credit counseling (which is a part of every bankruptcy filing) will teach you alternatives to bankruptcy, many people jump on their first assumptions and try to file a Chapter 7. Chapter 7 bankruptcy filings are great — they eliminate most of your debt, you do get to keep some of your property, and they give you a fresh start. But, many people will be uncomfortable with giving up most of their valuable possessions, especially if they live in a state that limits how much of their house they can keep or doesn’t allow them to keep a car at all — for those people, bankruptcy may feel like financial suicide, since they will still emerge with a clean debt sheet but no place to live and no way to get to work.
A minority of people decide to go with the second most popular type of bankruptcy: the Chapter 13 repayment plan. Under this type of bankruptcy, you don’t get out of all of your debt or even the majority of it, but you do get to keep your assets so long as you can afford to continue making payments. Essentially, all of your debt is restructured so that you are making one payment every month for a few years, and at the end of it, leftover debt is discharged and you emerge with a healthier and more stable financial picture — plus you get to keep your stuff.
You Eliminate Significant Debt in a Chapter 13 Filing
While a Chapter 13 filing is more about repaying the debts you owe than escaping them, you may have some debt eliminated as part of your case. After three to five years of making payments on your repayment plan, any remaining nonpriority unsecured debt is written off. Examples of this type of debt include:
- credit card debt
- medical bills
- payday loans or personal loans
In addition, there are actually some kinds of debt that you can discharge in a Chapter 13 filing that cannot be discharged in a Chapter 7 filing:
- debts arising out of willful and malicious damage to property
- debts from nondischargeable tax obligations
- debts from a divorce settlement, other than alimony or child support
- retirement account loans
If any of these debts are weighing you down, you may be one of the people who is better served with a Chapter 13 filing than a Chapter 7, though that is certainly a topic you should discuss with an attorney before making a decision.
Crammed Down Debts
The most well-kept secret in bankruptcy filings is the ability to set aside overleveraged debt on your house and car through bankruptcy. For example, if you owe more on your house than it is worth on the open market, and you have a second mortgage or a HELOC (home equity loan), you may be able to have that first mortgage reduced to the value of the house through a cramdown and extra liens wiped out through stripping the debt. As a bonus, so long as you can keep up your mortgage payments, you get to keep the house.
Cramdowns are easiest to explain with an example: let’s say you purchased a car a few years ago. Unfortunately, the car depreciated fast because you put a lot of miles on it. To put numbers on it, let’s say you paid $30,000 three years ago, but now, the car is only worth $10,000, yet you still owe about $20,000.
You might want to just walk away from the car and tell them to keep it, but given how crazy the market is, maybe you just want to hold on to your car. In a Chapter 13 filing, the $20,000 you owe is basically split between what the property is worth, which becomes a secured loan, and the extra debt above that worth, which becomes an unsecured loan. In this case, if you kept the car, you would definitely owe the $10,000 and it would be secured by the title of the vehicle (so if you don’t pay, they will take the car). The other $10,000 is unsecured debt and you will pay on that during your bankruptcy repayment plan, but most people don’t come anywhere close to paying the full amount during that plan — especially if they have a lot of other unsecured debt to chip away at during that plan.
The same idea goes for your house: during the last major recession and housing crisis, many people who purchased their homes at the height of the mania found themselves deeply behind on their mortgages when the economy crashed and their home values plummeted — not only were they having trouble making their monthly payments, but they found out that their homes were now worth half (or even less) of what they paid for it. A cramdown as part of a chapter 13 filing is an interesting tool for this sort of situation — the borrower would only be on the hook for the actual value of the house, while the remaining balance owed would be paid down during a five-year repayment, then discharged.
All of that sounds great, right? However, there is a catch: the amount that you still owe after the cramdown (the secured half of the above examples) must be paid in full during the three or five-year Chapter 13 repayment plan.
That’s a very big ask of someone who is in desperate enough financial straits to file for bankruptcy.
In addition to having a massive primary mortgage, many borrowers also have a second mortgage or a home equity line of credit loan on their house. These secondary loans are also secured by liens on the house, but they are much easier to strip away in bankruptcy — if the first mortgage on your property is already more than the property is worth, the liens on junior mortgages are “stripped” and these additional mortgages or home equity loans should be classified as unsecured debt (leaving it in the same category as credit card debt, overdue hospital bills, and the like). That means you will only have to make partial repayment during your five-year repayment plan. Any remaining balance at the end of the payment plan should be discharged.
Discuss Your Options — All of Them — With an Experienced Attorney
At first glance, a Chapter 13 filing may sound like a bad deal — other people are filing bankruptcy and walking away debt free, while you have to make payments for five years before getting some relief. However, the numerous advantages of a chapter 13 filing, such as getting to keep your property, eliminating some types of debt that can’t be discharged in a chapter 7 filing, and the possible, though likely unaffordable, potential cramdown of debts on your home and car, make Chapter 13 an increasingly intriguing option once you learn more about it. Given all the complexities of property exemptions, junior liens stripped and crammed debt, and numerous types of repayment plans, the benefits of talking through your options with an experienced bankruptcy attorney before jumping into filing on your own are obvious. Get in touch with a bankruptcy attorney near you today.