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Chapter 7 vs. Chapter 13: the Easy Choice, and the Better One

Picking the right Chapter to use to file your bankruptcy case can be simple or very, very difficult. And appearances can be deceiving.

First take a look at this video I recorded about the basic differences between Chapter 7 and Chapter 13.  

A situation that seems at first to call for an obvious choice can turn out to have a twist or two that turns the case upside down.  

That twist can come in the form of an unexpected disadvantage in filing a bankruptcy under the intended Chapter, or an unexpected advantage in filing under the other Chapter.

Let me be clear. The majority of my clients walk into their first meeting with me with a pretty good idea of whether they want to file a Chapter 7 or a 13.  After all, there is a lot of information available—like this blog that you’re reading. So lots of my clients come in having read up on their alternatives. Whether their inclination to file one or the other Chapter comes from their head or from their gut, it’s often correct.

But sometimes it’s not.

That shouldn’t be a surprise. Although the main differences between Chapter 7 and Chapter 13 can be outlined in a few sentences, there are in fact dozens of  subtle but crucial differences. Many of them don’t matter in most situations, but sometimes one or two differences can determine what’s best in your case. If you don’t know the differences you could end up filing under the wrong chapter and paying the consequences for many years.

Here’s an example: Imagine that you have a house that you’ve been trying to hang onto for years.  But now, due to the current economy, you’ve pretty much given up on keeping it. You’ve fallen behind on both the first and the second mortgage. And with the decline in housing values over the last several years, the house is now worth less than the amount you owe on the first mortgage.  And say you owe $80,000 on the second mortgage. With good reason you doubt that the market value will improve enough to give you any equity for many years.  You would love to keep living in the house so your kids can stay in their schools and be close to their friends, but it may not make financial sense to try to hang onto something worth significantly less than what you owe. Besides, you just don’t have the money to pay both mortgages. So you figure it’s time to give up on the house and just start fresh with a Chapter 7 “straight bankruptcy.”

But then you learn from your bankruptcy attorney that if your home is worth less than the balance on the first mortgage, through a Chapter 13 case you can “strip” the second mortgage from the title of your home. The seond becomes an unsecured debt and is lumped in with the rest of your unsecured debt (like credit cards or medical bills). By paying into your Chapter 13 Plan, you may be able to keep your home by paying very little—or  nothing—on the second mortgage.  At the end of your case, whatever amount is left unpaid on that second will be “discharged”—legally written-off—so you will then own the house without that mortgage and have essentially no debt, except for the balance on the first.  

This “stripping” of the second mortgage is NOT available under the Chapter 7 case that you initially thought you should file. Saving your home by lowering your payments on it may well swing your choice in the Chapter 13 direction.

This is just one illustration of many ways that the option you initially think is better might not be. So keep an open mind about your options when you first consult with your attorney. Communicate your goals to him or her, and be clear about why you think one Chapter sounds better to you than the other. In the end, after laying out your story and hearing the attorney’s advice, it’s ultimately YOUR choice. But do yourself a favor and be flexible, because you might end up with a better deal at the end of your meeting than you thought was possible at the beginning of it.

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