When Alphonzo Kershaw fell behind on the mortgage of a second home last year, he filed for Chapter 13 bankruptcy, which would prevent a foreclosure and enable him to pay back more than $40,000 in past due mortgage payments and real estate taxes over a five-year period. “I believed I would be able to pay it off,†says the 68-year-old retired executive chef from Philadelphia. However, five months later, health problems and mounting bills made it difficult for Kershaw to keep up with $750 monthly installments under the court-ordered repayment plan.
Had Kershaw filed for Chapter 7 bankruptcy protection from the start, he would have lost the house, but walked away from the entire debt. A conversion from a Chapter 13 bankruptcy to a Chapter 7 bankruptcy is a viable option for those like Kershaw who are unable to complete the three-to-five-year required repayment plan. By converting to a Chapter 7, Kershaw was able to discharge his debts, including the $80,000 mortgage, property taxes, and credit card balances.
Circumstances such as a medical issue or a loss of income can prompt someone to switch from Chapter 13 to Chapter 7. Often people get started on a repayment plan, but then can’t afford it, says Théda W. Page, a Frisco, Texas-based bankruptcy attorney and owner of The Page Law Firm.
The vast majority of debtors file under Chapter 7 of the bankruptcy code, which allows them to erase most unsecured debts in a matter of months. A Chapter 7 bankruptcy is a liquidation of non-exempt assets, says William E. Brewer Jr., president of the National Association of Consumer Bankruptcy Attorneys and a practicing lawyer in Raleigh, North Carolina. Filing Chapter 7 does not discharge financial obligations such as back taxes, child support, alimony, and student loans. Chapter 13 was designed to stop foreclosure, repossession, garnishing wages, and lawsuits. Under a Chapter 13 bankruptcy, a debt repayment plan requires filers to dedicate their disposable income to catch up on their delinquent accounts, such as mortgage or car payments, over three to five years.
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The cost for filing Chapter 7 is about $1,500 for a lawyer plus a filing fee of $306 versus roughly $3,500 for a lawyer plus a filing fee of $281 for Chapter 13 (attorney fees are paid mostly as part of the repayment plan). Nearly two of every three Chapter 13 plans are not completed, which means the filers’ remaining debts are not discharged, leaving them right where they started. If a bankruptcy case is dismissed, creditors can resume their collection activity, including car repossessions, home foreclosures, and the garnishment of wages. If all payments are made, at the end of the repayment period the filer typically keeps his or her property and the court has the option of discharging all unsecured debts.
A recent study by researchers from the University of Illinois and University of Arizona found that African Americans are twice as likely as whites to wind up in Chapter 13 bankruptcies as they try to dig out from their debts. Evidence suggested that bankruptcy lawyers steered black debtors into filing Chapter 13 more so than whites even when they had similar financial challenges.
African Americans as a whole are more likely to file Chapter 13 to try to save a house or a car, or because they feel a moral obligation to pay their debts back, says Waverley Madden, a bankruptcy attorney, of her experiences dealing with clients of her firm, the Philadelphia-based Madden Law Firm P.C. If circumstances change, for example you have a new job–and you fell behind because of a job loss–then filing Chapter 13 makes sense to try and play catch-up. It would allow you to consolidate, prioritize, repay, and, in some cases, reduce or eliminate old debts while receiving the protection against creditors that the bankruptcy court provides.
While a Chapter 7 bankruptcy offers more financial relief, it has become more difficult to qualify under the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005. You must pass a “means test,†which reviews factors such as income and debt load to determine one’s ability to repay all debts. For example, if your monthly income
minus certain expenses and debt payments exceeds a certain amount, then the court would say you have enough disposable income to pay your debts over an extended period of time, so you’d be denied the right to have your debts discharged under Chapter 7.(Continued on next page)
People choose to file Chapter 13 over Chapter 7 in order to hold onto certain assets, says Madden. When your trustee files under Chapter 7, you’re obligated to sell assets to pay off debts, with the exception of a protected amount that varies by state. For example, in North Carolina, you can protect $35,000 in home equity, but if your house is worth more than that, you must sell the property and use all but $35,000 of the proceeds to pay off debts.
Should you decide to convert from a Chapter 13 to a Chapter 7 bankruptcy, the process varies depending on the bankruptcy court, says David Haynes, a California bankruptcy attorney. For example, courts require you to file a formal written request, but some may also require a hearing where you will appear before a bankruptcy judge.
Another option for those unable to complete a Chapter 13 repayment plan is to request a hardship discharge, which relieves the filer of the rest of his or her obligations. However, a Chapter 13 hardship discharge is rarely granted, says Madden. To qualify, a debtor must prove
that he or she cannot make the payments under no fault of their own but because of extreme circumstances, such as severe illness. Creditors must have received as much as they would have gained through a Chapter 7 bankruptcy, and a Chapter 13 modification must be shown to be impossible. The filer would likely lose any property covered under the repayment plan.When it comes to credit implications, regardless of the chapter filed, a bankruptcy can lead to a 250-plus point FICO score drop for someone whose score previously was in the high 700s, says John Ulzheimer, president of consumer education for SmartCredit.com. The main difference is the amount of time the bankruptcy stays on your credit report, he adds. A Chapter 7 bankruptcy remains on your credit report for 10 years from the filing date while a Chapter 13 bankruptcy stays on for seven years from the discharge date. So, if you complete your Chapter 13 plan in five years, it would still remain on your credit report for 12 years. However, when you convert from a Chapter 13 to a Chapter 7, the countdown to the day that the bankruptcy drops off your credit report starts over with the filing date, Ulzheimer says.
For many, the credit hit is outweighed by the lure of a second chance. “Converting to Chapter 7 was a huge relief,†says Kershaw.