What Makes Chapter 13 Bankruptcy a Bad Idea?

Bankruptcy laws exist for those whose debt has become unmanageable. Whether it’s bad fortune (think medical bills or a lost job) or financial irresponsibility (think reckless spending with credit cards, cars or home), filing bankruptcy does provide the opportunity to alleviate the debt.

In the U.S. system, the two most common types of bankruptcy are Chapter 7 and Chapter 13. In Chapter 7 bankruptcy, people can erase debts with an agreed-on lump-sum payment, but to do so they must liquidate assets that are not exempt. In Chapter 13 bankruptcy, you can keep property but you must agree to a three-to-five year plan to repay debts, then stick to the plan religiously.

What’s better? The knee-jerk is to say Chapter 13 because it allows you to keep your assets, including your home, provided you can pay the mortgage as well as bankruptcy payments.

But there are pratfalls and dangers in Chapter 13 that are not present in Chapter 7. A ProPublica study in 2017 even found that those filing Chapter 7 were far more successful in resolving their cases. From 2008-2015, 96% of Chapter 7 filings received a discharge of debt. Only 41% saw a discharge filing Chapter 13.

The pros and cons of bankruptcy Chapter 13 mean it’s not always the best option, and for some it’s simply a bad idea. Among the concerns:

• Far higher failure rate than Chapter 7
• High fees and costs
• It can affect your finances
• It impacts African-Americans more severely
• If the bankruptcy fails, you can lose your home and assets
• Lower chance of success
• Because of failure, it does not help budgeting skills

1. Chapter 13 Failure Rate

Life happens, which means the unexpected is the norm. Most bankruptcy filers in Chapter 13 work out a five-year payment plan, and in five years a lot can happen.

The unexpected could range from medical bills to funeral costs to a car accident to children needing money for college to losing your job or having your salary cut. As 2019 ended, very few of us expected a pandemic and COVID-19 would derail the economy in 2020. Imagine filing for Chapter 13 bankruptcy, then being among the 30 million who lost a job in 2020?

Even making it to the end of the five-year timeframe does not mean all debts have been forgiven. Qualifying debt is erased, yes, but things like child support and student loans are not (write your representatives and senators if that student loan fact makes you angry). At that point, you have to re-assess where you are and what you can do about remaining obligations.

2. Chapter 13: High Fees & Costs

The main cost for filing Chapter 13 is the attorney. While technically any individual can file for bankruptcy on his/her or own, i.e. without an attorney, there is almost universal agreement that filing Chapter 13 without an attorney is a bad idea. A very bad idea.

The attorney is an added bankruptcy cost, but not doing so may wind up costing more in the long run.

How much is bankruptcy Chapter 13? The average cost for a reputable bankruptcy lawyer in Chapter 13 is about $3,000-to-$4,000, and perhaps more if the case is complex. This payment does not have to be paid as a lump sum, but can be paid over time.

The U.S. Bankruptcy Court for the Central District of California tracks bankruptcy statistics, and reports that in 2017 and 2018 69% of those who filed Chapter 13 with an attorney had a successful outcome, but less than 3% of those who filed without one were successful.

Those should be convincing statistics.

3. Chapter 13 Bankruptcy is Bad For Your Finances

The 2017 and ’18 numbers show that almost one-in-three Chapter 13 filings result in dismissal, which is not the result you’re seeking. Dismissal means creditors again can start procedures to pursue debt, garnish income or foreclose on property. Money you had paid in the payment plan suddenly is applied to interest on debts that had been held in abeyance, which means you will owe more than when you started.

In addition, you have lost the protection that bankruptcy provides, you’ve paid filing and court fees and owe the attorney. And your credit score has taken a hit for the next seven years. It all happened without gaining a single benefit of the fresh start bankruptcy is supposed to provide.

4. Chapter 13: 50% Worse for Black Debtors

The numbers do not paint an equitable picture for the way African-American filers are treated.

Another ProPublica study in 2017 showed that the chances are more than twice as high that black debtors will choose the more expensive and complex Chapter 13 filing when compared to white debtors with a similar financial situation. Once the filings are completed, the chances of a case being dismissed are twice as high for blacks as for whites.

The cause for these numbers can be debated, but they do speak loudly.

5. You Don’t Get to Keep Assets If You Fail

The idea of keeping your home and car and personal belongings is an attractive part of Chapter 13. But if the case fails or is dismissed, protection for those assets disappears. With a fairly high number of unsuccessful cases, this has to be kept in mind.

ProPublica told of a Memphis mother earning $9 an hour with rent, $19,000 in student loans and $1,100 in a car loan as some of her expense. When her work hours were cut, she turned to bankruptcy and filed Chapter 13 because she wasn’t familiar with the difference between that and Chapter 7.

But what she called a miscommunication with her attorney led to her case being dismissed less than six months after she filed. Any money she paid went to her attorney and court fees, and interest on her loans – including a car loan interest many times above the norm – accrued. Collections agencies started contacting her soon after the dismissal. She was pondering filing again to keep her car so she could to go work.

Another Memphis woman filed Chapter 13 four times in seven years, all in hopes she could keep her car. She lost her job 18 months after the first filing and saw her case dismissed. She used unemployment benefits to make payments after filing the second time, until they ran out. Another dismissal. She filed a third time, and the case again was dismissed. She got another job, filed again and admitted she had spent the better part of a decade filing bankruptcy to keep her car.

Was it worth it?

6. No Money Down, But Less Chance of Success

Because Chapter 13 attorney’s fees can be paid over time, it’s sometimes referred to as “no money down.” But, the money is still due – sort of like the cell phone company that offers a “free” phone, then makes you pay $34.99 per month for it for 24 months. It really wasn’t free.

No money down and extended payments is a great idea if you are in good financial shape, but by definition people who turn to bankruptcy are not in good financial shape, so they are merely adding more debt via extended attorney’s fees when they file Chapter 13.

Chapter 7 is simpler than Chapter 13, and if a bankruptcy case is relatively easy to grasp, it’s almost always better to file Chapter 7 – even though attorney fees have to be paid up front. A 2017 study showed “no money down” filers paid $2,000 more in attorney fees and had cases dismissed 18 times more often than if they had simply filed Chapter 7.

7. Low Chances of Chapter 13 Success Offers No Improvement to Budgeting Skills

It seems logical that the Chapter 13 will force people to sit down, develop a budget and stick to it. The court-ordered payment will not change for the agreed on timeframe – usually five years – and the relief from paying numerous debts has been mitigated.

This makes sense, provided the filer is diligent about payments and responsible about having bankruptcy discharged. The 30% or so of filers who are not responsible about ensuring they address what brought them to bankruptcy show they have not learned.

Those who fail to complete the payment requirements see no lasting debt relief, which makes finding the wherewithal to develop a budget and stick to it, next to impossible.

Alternatives for Chapter 13 Bankruptcy

Nobody should stick their nose in the air toward those who have to file bankruptcy. However, bankruptcy should really be a last resort, and there are serious questions to address. Should I file Chapter 13? Is Chapter 13 worth it? Is Chapter 13 bad? Those are all important considerations for filers, who would be wise to consider every option before taking that last-resort step of bankruptcy. Among the options:

Chapter 7 Bankruptcy

Filing Chapter 7 bankruptcy should always be a consideration before filing Chapter 13. It’s typically simpler and easier, and it results in a successful discharge far more often. Also, it’s faster. The average Chapter 7 bankruptcy typically lasts three or four months, from filing to discharge.

If you are worried about keeping your house, you may claim exemptions to property and belongings that are essential to your life. You must continue to make payments on the house or car, but there are ways in Chapter 7 to settle debts and keep what you need. About 96% of Chapter 7 filers had their debts discharged.

The first meeting with an attorney, called a consult, is typically free. It’s wise to go over the options with bankruptcy then; you may find Chapter 7 is an easier and faster process.

Debt Management Program

This program is handled by nonprofit credit counseling agencies, and addresses the repayment of debt to avoid filing bankruptcy. Typically creditors would agree with the debt management program’s proposal of a three-to-five year payment plan that is affordable to you and agreeable to the creditors.

These debt management programs typically address unsecured debt – credit cards, medical bills, student loans. A single monthly payment is made to the credit counseling organization, which then makes payments to creditors based on the agreed-on schedule.

Debt Consolidation

Consolidation focuses on hefty credit card debt. Debt consolidation combines different loans into one, at a lower interest rate. Instead of making several payments at hefty credit card interest rates, one payment is made to one source, at a lower interest rate.

Debt Settlement

In this agreement between you and creditors, discussions lead to the lender accepting less than the amount owed. This is a viable option to bankruptcy because lenders will be willing to settle a debt because they prefer getting something to nothing, which may happen in bankruptcy.

Credit card debt may be an option for debt settlement, but student loan debt is not. Talk to a professional to sort out the options.

Credit Counseling

Sometimes sitting down and talking to a professional can help sort through the maze of debt and finances. Credit counseling is designed to help people avoid bankruptcy. Often the professionals are non-profit counselors.

These counselors can offer advice on budgeting, managing money and other important basics of personal finance. They also can help sort out debt, and can offer their best solution (consolidation, settlement, etc.) to the individual situation.