Considering Bankruptcy? What Happens To Your Loans?

Posted on: 26 December 2014

If you're pondering the pros and cons of filing for bankruptcy, you may be wondering whether this filing will even be able to discharge all your debt. And if you're prohibited from a Chapter 7 filing, you may be wondering whether you'll ever be able to successfully complete a Chapter 13 repayment plan. However, there are some special provisions included within Chapter 13 of the U.S. Bankruptcy Code that can allow you to eliminate certain types of loans outright. Read on to learn more about how lien stripping in chapter 13 bankruptcy works and whether it can benefit you.

Why choose a Chapter 13 bankruptcy over a Chapter 7 bankruptcy?

If you've done some investigation, you may already know that the primary difference between these types of bankruptcy is the required repayment plan of a Chapter 13 bankruptcy as compared to the debt discharge of a Chapter 7 bankruptcy. On the surface, a Chapter 7 generally seems like the better option -- why repay your debt when you can simply eliminate it through discharge? However, there are several reasons that could

The first barriers to a Chapter 7 bankruptcy filing are the income and debt limits. If the bankruptcy trustee determines that you have sufficient income to repay all or most of your debts over a certain period of time (usually 3 to 5 years), you may be ineligible for a Chapter 7 discharge.

The second reason many debtors choose a Chapter 13 repayment plan is the lesser hit to their credit reports. Although a Chapter 13 bankruptcy is still reported as a black mark to the credit bureaus, it generally doesn't cause your credit score to drop as far or for as long as in a Chapter 7 bankruptcy. And if you successfully complete your 3-to-5 year Chapter 13 repayment plan, your credit score immediately begins to improve.

What happens to your debts in a Chapter 13 bankruptcy?

When you enter a Chapter 13 bankruptcy, the bankruptcy trustee will sit down with you to carefully review your income and debts. You'll be asked to estimate a realistic but austere budget for a number of discretionary, non-debt items (such as groceries, utilities, child care, transportation, and other costs). Each pay period, you'll be permitted to keep the average cost of these expenses. All other income will be directly deposited with the bankruptcy trustee, who will portion it out to your debtors according to priority and total debt load.

There are certain debts that are not affected by a Chapter 13 bankruptcy. For example, if you owe child support or alimony payments to an ex-spouse, these funds pass outside the trustee, as part of your discretionary budget -- and you can face severe penalties or even have your bankruptcy filing ejected if you fall behind on these payments.

What if you owe more than an asset is worth?

Under some Chapter 13 circumstances, your debts may be eliminated (similar to a Chapter 7 discharge) rather than repaid. This is termed "lien stripping," and generally comes into play when you owe substantially more on an asset than the asset's value. For example, if your home is valued at $200,000, but you have a $190,000 mortgage and a $30,000 home equity loan you used to make minor improvements, the bankruptcy trustee may be able to "strip" this home equity loan. If your house was sold at a tax or foreclosure sale, it's unlikely it would fetch enough money to pay off the home equity loan. For this reason, this excess loan is termed "unsecured" and is therefore eligible for discharge.

If you're unsure whether you are able to repay your debts, a Chapter 13 filing may still be worthwhile because of its ability to reduce the total amount of debt you must repay.