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Chapter 13 bankruptcy: How it works


Unlike Chapter 7 liquidation plans, Chapter 13s give filers a chance to pay off debts over three to five years — but they rarely turn out as planned.

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For hundreds of thousands of Americans each year, filing for bankruptcy doesn’t mean erasing most debts in one fell swoop.

Instead, the process can take up to five years for those who want to save their assets and file under Chapter 13 of the bankruptcy code.

“Chapter 13 gives you an opportunity to save your house and maneuver around student loans,” says Henry Hildebrand III, a Chapter 13 bankruptcy trustee based in Nashville.

Chapter 13 bankruptcy: How it works

In 2012, nearly 1.175 million consumer bankruptcy filings in the 50 states and District of Columbia, with 70 percent filed under Chapter 7 and the rest filed under Chapter 13.

Using Chapter 7, consumers have their assets sold, but are able to walk away from most of their debts and the process takes just a few months. Under Chapter 13, consumers pay part or all of their debts under a tightly controlled budget plan overseen by a court-appointed bankruptcy trustee. The Chapter 13 process, also called reorganization bankruptcy, takes three to five years.

“In the South, Chapter 13s are much more common for cultural and economic reasons,” says Edward Boltz, a bankruptcy attorney in Durham, N.C., and president of the National Association of Consumer Bankruptcy Attorneys.

They made up more than half the filings in Alabama, Georgia, Louisiana, North Carolina, Tennessee and Texas in 2012.

While no one knows exactly why that is, some say one factor is that the South is more religious, and Southerners feel they need to try to repay their debts, Boltz says.

There’s also a “little bit of pessimism involved,” Boltz says, as people think, “‘I need to try to save my house. I’ll never get another one. This is my one shot at the American Dream.’

“That’s usually a false assumption,” he says.

If you’re considering filing for bankruptcy, your first step is to attend a credit counseling session run by a government-approved organization. Then you’ll receive a certification confirming that you completed the course and then can file.

During the session you’ll be asked about your financial situation — income, expenses, assets, debts and goals — and the counselor will help you figure out how to proceed.

If you make more than the median income for your state, you must complete a means test, which compares monthly income and expenses. If you have enough money left at the end of the month to pay at least part of your unsecured debts, such as credit cards, you must file under Chapter 13, says Claire Ann Resop, a bankruptcy attorney and former Chapter 7 bankruptcy trustee in Madison, Wis.

Resop’s clients usually want to file under Chapter 7. “They don’t want to have to be in bankruptcy for five years.”

But some opt for Chapter 13, particularly if they have children at home and don’t want to disrupt their kids’ lives. “It’s a very different proposition for people. It’s very emotional.”

“They’ve got to be willing to commit and go after a certain path,” says Todd Mark, vice president of education for the Consumer Credit Counseling Services of Greater Dallas.

Chapter 13 and assets

By filing under Chapter 13, you’ll be able to keep your assets and pay all or part of your debt over the course of up to five years. It gives you a chance to stop any foreclosure proceedings and catch up on your mortgage payments.

Some debts must be paid in full, such as “priority debts,” including certain tax payments, child support and alimony. To keep your secured assets, such as your car and house, you’ll need to show you have enough income to continue paying for them.

With unsecured debts, you may pay between nothing and up to 100 percent of what you owe. In the majority of the cases he handles, Boltz says his clients pay nothing toward their unsecured debts. Typically, a trustee will collect your money each month and disburse it to your creditors.

However the Chapter 13 plan is drawn, living with it is no walk in the park. It gets complicated: How much you have to pay depends on the interplay between your state exemption laws, federal law, your marital status and what types of assets you have. By filing under Chapter 13, “you’re put on an incredibly tight budget,” Resop says. “People who start in this situation find it very difficult to maintain this kind of strict budget for five years.”

At the same time, bankruptcy trustees realize crises happen, so if your car dies or your daughter gets sick, they’ll work with you so you can make up payments you missed, she says. “It’s a very forgiving system.”

Boltz says he sees “people who buy cars and houses on financing fairly regularly” when they’re repaying their debts under Chapter 13. “Lenders lend to people who are in bankruptcy,” though they will face higher interest rates.

Chapter 13 failures common

One drawback to filing under Chapter 13 is that people don’t often complete the process. Hildebrand says it’s often an issue for those who are “financially fragile,” and go through repeated cycles of employment and unemployment.

U.S. Bankruptcy Court data show 240,000 Chapter 13 cases were closed in 2011, with just 22 percent completed, while the vast majority were dismissed.

For those who fail, the case can be converted to a Chapter 7, and your assets are sold off, Boltz says. Or the case may be dismissed, and you’ll be in an even worse position than when you started: Along with owing your original debt, you’ll also owe retroactive interest.

If you complete the plan, you’ll be current on your mortgage and car payment, but your unsecured debts will be zeroed out, Boltz says.

You’ll also have to complete a post-bankruptcy education course. The aim is to “help them emerge a stronger consumer through the bankruptcy process,” Mark says. “We don’t want them to recycle the same patterns afterward.”

The damage after filing

Your credit score will take a hit when you file for bankruptcy, but the impact will depend on your previous credit history, says Frederic Huynh, senior principal scientist at FICO, which has the most commonly used credit score.

If you had good credit till that point, your score may plunge by more than 100 points.

But if you already have a bad history, and your score is low, it may not fall by much, Huynh says.

Rebuilding after bankruptcy

It’s important to start rebuilding your credit as soon as possible, and that can begin even as some of its effects linger. A Chapter 13 filing can stay on your credit report for seven years, while a Chapter 7 filing remains for 10 years.

During that time, it’s important to get new credit or “your credit history is frozen at the point of your bankruptcy,” says Mark.

While it may be tempting to pay all your bills with cash, that won’t show up on your credit report. “You don’t establish a new, positive pattern of behavior,” Mark says.

If you file under Chapter 13, you still may have credit cards that didn’t have balances on them and weren’t included in the filing. He recommends using them, but keeping the balances low and paying them off in full.

While nothing but time can erase the bankruptcy from your credit report, if you keep your balances low and pay your bills on time, after a couple of years the bankruptcy will carry less weight, Mark says. “You should show good behavior moving forward and don’t do anything that would jeopardize that.”

See related:5 basic bankruptcy tips

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