Chapter 13 Bankruptcy: A Different Way to Deal with Debt
The common perception of a bankruptcy includes: a person filing a bankruptcy a case, attending a hearing, and receiving a discharge of debt. However, there is another chapter to this story and that is a bankruptcy under chapter 13 of the bankruptcy code. When considering bankruptcy options, there are hundreds of variables to consider. Some of the questions that need answers, include: Are you behind on your home payments (“mortgage”)? Do you have overwhelming tax debt? Can you restructure a bad car loan? Is there a way to keep assets and still get out debt? Depending on the answers to various bankruptcy considerations, a chapter 13 might be the best way to deal with debts in a laser-like manner.
How is a chapter 13 different than a chapter 7?
At the end of a chapter 7 or chapter 13 bankruptcy, debts are discharged. However, there are legal and procedural differences between a chapter 7 and a chapter 13. For starters, the time a debtor is in a chapter 7 is typically 3 months whereas a debtor can be in a chapter 13 for 3 to 5 years. In a chapter 7, a debtor does not make payments for the debts; however, in a chapter 13, a debtor makes monthly payments on debts.
How does a chapter 13 work?
From the debtor’s perspective, a chapter 13 functions much like a consolidation loan. A debtor makes one payment a month for all the debts included in the chapter 13 for the term of the chapter 13. A trustee is assigned to the debtor’s case to distribute the money paid into the chapter 13 for the debtor’s debts as prescribed by bankruptcy law.
The lump sum payment made by the debtor is broken up into different parts. For example, the debtor’s attorney fees are paid from the debtor’s chapter 13 payments. In addition, the trustee is paid a small percentage of each payment for administering the chapter 13. Finally, the trustee pays the debtor’s debts according to the chapter 13 plan approved by the bankruptcy court. Upon final completion of the plan, the debts remaining in the plan (except for debts that are non-dischargeable) are discharged.
Why do you file a chapter 13?
The critical question is why does a person file for chapter 13 bankruptcy protection instead of chapter 7 bankruptcy protection. The answer is found in the details of the debtor’s situation, including the debtor’s debt, assets, and various timing considerations.
Behind on Secured Debts
A chapter 13 is a good way for a debtor who is behind on secured debts to pay the arrears and (potentially) keep the asset. For example, homes are often saved from foreclosure by filing for a chapter 13.
Not Qualifying for a Chapter 7
A chapter 13 is an alternative to a debtor that does not qualify for a chapter 7 due to income complications. Income complications can arise under the means test or the actual “real-time” budget. The basic issue is that the debtor’s income is higher than expenses.
Not Eligible for Discharge in a Chapter 7
Bankruptcy law allows a debtor to file a chapter 7 every 8 years. What happens when debt issues arise within 8 years of a debtor filing a chapter 7? The debtor can often file a chapter 13 to manage the debt issues.
The bankruptcy code classifies debts into many different categories. Additionally, the bankruptcy code dictates terms for the repayment of certain debts. Depending on various factors and classification, it may benefit a debtor to pay debts in a chapter 13 as it is more economical to do so.
Protection of Assets
Bankruptcy law allows for the protection of specific assets of the debtor. What happens when a debtor has assets that cannot be protected by bankruptcy law? The debtor can often file a chapter 13, pay the creditors for the value of the assets, and in return, keep the assets from the reach of creditors.
How are debts handled in a chapter 13?
The power of a chapter 13 is the way debts are paid back within the chapter 13 plan. The debts are categorized by the nature of the debt, submitted to the court as a chapter 13 plan, the plan is confirmed by a bankruptcy judge, and the creditors are paid according to the plan submitted to the bankruptcy court by the trustee.
A person’s home is usually the most important investment for most of us. The qualifications to purchase a home include a stable source of income. What happens if that income disappears? What happens if a life changing event happens that alters your ability to pay the monthly mortgage payment? Simply said – you start to get behind on your mortgage.
A mortgage company will usually wait until a mortgage is 6 months behind to initiate foreclosure proceedings. According to the U.S. Census Bureau, the average mortgage payment is around $1,500 a month. With an average mortgage payment, a debtor will have close to $10,000 in mortgage arrears for the 6 months mortgage payments were not made by the debtor. The mortgage company will want the entire amount to avert a foreclosure of the home.
How can a debtor, who got behind on the mortgage due to a loss of income, retain the debtor’s home now that the debtor has a new source of income? One solution is to file a chapter 13 to pay the mortgage arrears. Bankruptcy law allows a debtor to pay the mortgage arrears in the chapter 13. Thus, instead of a lump sum payment to the mortgage company, a debtor can make monthly payments for up to 60 months to get the mortgage current.
Once the chapter 13 is filed, the debtor will have to start paying the regular mortgage payment again. It is important for the debtor to keep the mortgage current after the filing of the chapter 13 to prevent the mortgage company from withdrawing from the chapter 13 and initiating a new foreclosure action. But, upon completion of the plan, the debtor becomes fully current on the mortgage.
For myriad reasons, a debtor can incur tax debt. How can a debtor deal with the tax debt? There are several options. For example, calling the taxing authority and setting-up a monthly payment with interest or hiring a tax attorney to get some or all the tax debt abated (which can be a daunting and difficult process). However, a solution that could be the best solution is to file a chapter 13.
Income taxes are dischargeable in a bankruptcy if the taxes fit the rules for discharge. There are three main rules for discharging taxes: First, the tax must be 3 years or older from when it first became due (typically April 15th of the following tax year). Second, the return must be filed for more than 2 years. Third, there cannot be an assessment within the past 240 days. If the tax fits these three main rules and there are no tolling events, the tax could be dischargeable in a bankruptcy.
If a person files a chapter 13 with taxes that fit into the dischargeable bucket, then the debtor can treat the tax debt like any common debt (e.g. credit card or medical debt). If the debtor has a mix of dischargeable and non-dischargeable taxes, the debtor pays 100% of the non-dischargeable taxes (with little to no interest) and pays the other tax debt along with the other general unsecured debt.
Paying a car loan in a chapter 13 has a few unique benefits. Simply stated, the debtor can pay a car loan in full in the chapter 13 plan if it is advantageous for the debtor to pay in the plan or the debtor can choose to pay the car loan outside of the plan.
One advantage of paying for the car in the chapter 13 plan is that the debtor can pay a reduced interest rate. Unfortunately, too many car loans have exorbitant interest rates. In a chapter 13, a debtor pays one to three percent interest plus the current prime interest rate. For example, if the current prime rate is 3.25%, the interest rate for the repayment of the car loan debt in a chapter 13 plan would be 4.25% to 6.25%. If a debtor has an interest rate higher than what is available in a chapter 13, it would be advantageous to put the car loan payment as part of the chapter 13 plan.
A unique benefit for the treatment of a car loan is what is commonly referred to as a “cramdown”. A cramdown allows the debtor to pay for the value of the car only (plus interest), not the entire loan. As an example, a debtor has a car loan with a balance of $18,000 and the car having a fair market value of $10,000. The debtor can pay the value of the car ($10,000) plus interest and treat the remaining $8,000 as a general unsecured debt (e.g. credit card). A cramdown is available to a debtor only if the car was purchased more than 910 days before the filing of the chapter 13 bankruptcy.
Currently, student loans are not dischargeable in a bankruptcy unless the debtor files an adversary proceeding (e.g. filing a lawsuit) against a student loan creditor; however, student loans can be paid in a chapter 13 plan. Paying student loans in a chapter 13 may only delay the repayment of the loans. As an example, if a debtor pays $5,000 of a $40,000 student loan in a chapter 13, the debtor will be responsible for the remaining balance after the completion of the chapter 13 plan plus interest. Unless the entire amount of the student loan is paid in the chapter 13 plan, the inclusion of the student loans in the chapter 13 can act as a delaying action to give the debtor time to fix other debt issues and come back to paying the student loans directly after the conclusion of the chapter 13 bankruptcy.
Debts that are 100% non-dischargeable, like back child support, can still be paid in a chapter 13. These types of debts are treated as a special category of debt and paid in full in a chapter 13. Paying these debts in a chapter 13 can give the debtor more favorable repayment terms.
Credit Cards/Medical Debt
The most common debt held by debtors is general unsecured non-priority debt. Typically, these debts include credit cards, medical debts, payday loans and other similar types of debts. While these are the most common type of debts, these debts have the least amount of protection in a chapter 13 bankruptcy. A debtor can pay back as little as 3% in a chapter 13. In simple terms, if a debtor has $20,000 in credit card debt, the amount paid back could be as low as $600 of the credit card debt.
Rebuilding Credit While in a Chapter 13
Typically, a debtor starts to rebuild credit after receiving a discharge in a chapter 7. However, a debtor in a chapter 13 does not have to wait until discharge to begin rebuilding credit. A debtor can begin rebuilding credit immediately after confirmation of a plan (typically 2 months after filing).
How quickly can a debtor rebuild credit while in a chapter 13 bankruptcy? While it is not easy, you must work at rebuilding your credit. It is entirely possible to obtain a credit score of 720 in 12 to 24 months after a confirmation of a chapter 13 plan. Rebuilding your credit and the federal laws which afford consumer protection is a subject for a future consumer installment of our blog.
Four Examples of Debt in a Chapter 13
The examples below are only examples. There are multiple scenarios and variations for these examples. These are meant only for illustrative purposes only.
Case Study One
Mortgage Arrears $10,000
Credit Card $25,000
Attorney Fees $ 3,500
Trustee Fees $ 1,475
Total Debt $39,975
The debtor wants to keep the home and would propose a plan that pays the mortgage arrears in full and a minimum to the credit card debt over 60 months.
Based upon the above, the debtor might pay $270 a month for 60 months and pay back a total of $16,200 and discharge the remaining $23,775.
Case Study Two
Priority Taxes $ 8,000
Non-Priority Taxes $10,000
Credit Cards $13,000
Student Loans $20,000
Attorney Fees $ 3,500
Trustee Fees $ 1,365
Total Debt $55,865
The debtor ran into some tax difficulties and proposes a plan that will pay back 100% of the priority taxes and a minimum to the remaining debts (non-priority taxes, credit cards and student loans) over 60 months.
Based upon the above, the debtor might pay back $250 a month for 60 months, and pay back a total of $15,000, discharge $21,860 and would have $19,010 in student loans to pay back after discharge.
Case Study Three
Car Loan $18,000 (fair market value of the car $10,000)
Credit Cards $20,000
Attorney Fees $ 3,000
Trustee Fees $ 1,519
Total Debt $42,519
The debtor can take advantage of a cramdown as the car loan was entered into more than 910 days prior to the filing of the bankruptcy. The debtor would pay back the fair market value of the car, plus interest and a minimum to the remaining debts (remainder of the car loan and credit cards) over 36 months.
Based upon the above, the debtor might pay back $464 a month for 36 months, and pay back a total of $16,704, keep the car, and discharge the remaining $25,815.
Case Study Four
Credit Cards $30,000
Medical Debts $12,000
Student Loans $50,000
Attorney Fees $ 3,500
Trustee Fees $ 1,850
Total Debt $97,350
In this case study, the debtor has $15,000 in non-exempt assets that the debtor wants to retain. In a chapter 13, the debtor must pay back at least $15,000 of the general non-priority debt over the course of 60 months.
Based upon the above, the debtor might pay back $339 a month for 60 months, and pay back a total of $20,350, keep the assets, and discharge the remaining $77,000.
As you can see, a chapter 13 repayment plan can effectively combine a debtor’s debts into a simple monthly payment plan that is more manageable and cost-effective than dealing with the debts on an individual basis. A chapter 13 bankruptcy can provide many benefits for a debtor – in the right situation.
What happens at the conclusion of a chapter 13 (or chapter 7)? How can a debtor rebuild credit? What laws are available to protect a debtor and provide the best chance to succeed? These questions have an answer in rebuilding credit and the protections afforded under the Fair Credit Reporting Act.