Imagine you're Alex, a graduate of the University of Illinois who finished school five years ago. You have student loans, some credit card debt, and a job that covers your living expenses. Things are going well until you need a medical procedure that requires unpaid time off work, leading to more credit card debt to cover your living costs. Over time, the debt spirals out of control, and you start missing payments.
You hear about bankruptcy, but the options—like Chapter 7, Chapter 11, and Chapter 13—sound confusing. What do they mean, and which one could help you?
Let’s break down each type of bankruptcy using Alex’s situation to make it easier to understand.
Chapter 7 Bankruptcy: Total Debt Relief Through Liquidation
Chapter 7 is meant for people with very little income who can’t realistically pay back their debts. If Alex decides to file for Chapter 7, this type of bankruptcy would involve liquidating or selling his non-exempt assets like a second car or luxury items to pay off debts. Non-exempt assets are property that belong to Alex that must be sold to help pay back the creditors he owes. Here's how it would apply to Alex:
- Eligibility: Alex would need to pass a "means test" to qualify. This “means test” is only for individuals and it determines whether his average monthly income for the last 6 months is low enough compared to his state's median income and household size. If Alex's average monthly income falls below the threshold, he could be eligible. If not, he would not be eligible for Chapter 7.
- Process: A court-appointed trustee will take control of any non-exempt assets—like a second car or luxury items—and sell them to pay off creditors. However, Alex could keep exempt property, like basic household items and possibly his primary vehicle, depending on state law.
- Debt Discharge: After selling any non-exempt assets, most of Alex’s unsecured debts (e.g., credit card bills, medical debt) would be discharged. This means that Alex will be released from personal liability for those debts. However, student loans are typically not discharged in Chapter 7 unless Alex can prove "undue hardship" which is extremely difficult.
- Outcome: Alex would get a fresh financial start but might lose some possessions that were sold to pay off the creditors. Filing for Chapter 7 would stay on Alex’s credit report for 10 years, potentially making it harder to get credit in the future.
Chapter 11 Bankruptcy: Reorganizing Debt for High-Earning Individuals or Businesses
If Alex had a small business struggling with debt, Chapter 11 could be a better option. This type of bankruptcy allows businesses and some individuals with large debts to reorganize and keep operating while paying off creditors. Here’s how it works:
- Eligibility: Chapter 11 is mostly for businesses, but individuals like Alex can file if they have significant assets or debts. There are no strict income limits or qualification tests like Chapter 7.
- Process: Instead of liquidating assets, Alex would propose a reorganization plan to pay creditors over time. This could involve negotiating lower interest rates or extending repayment deadlines while continuing to operate the business. Creditors would vote on whether to accept the plan, and the court would need to approve it.
- Reorganization Plan: Alex would remain in control of the business as a "debtor in possession," meaning he doesn’t lose assets unless the plan fails. The plan may include selling unnecessary assets or cutting expenses to free up cash for repayment.
- Outcome: If Alex successfully follows the plan, he could emerge from Chapter 11 with the business intact and debts under control. But if the plan fails, the case could convert to Chapter 7 bankruptcy. Chapter 11 bankruptcy stays on Alex’s credit report for 7 years.
Chapter 13 Bankruptcy: Repayment Plan for Individuals with a Steady Income
If Alex owns a house or a luxury car that he doesn’t want to give up in Chapter 7 bankruptcy, Chapter 13 might be the solution. This kind of bankruptcy allows individuals to get rid of their debt by promising to pay all their disposable income for the next 3-5 years to their creditors instead of giving up their nonexempt property. That is, Alex will give up any money left to spend, save, or invest after taxes and other necessary payments have been made to pay off creditors.
- Eligibility: Available only for individuals with regular income but not corporations, partnerships, and LLCs. Alex must have a steady income and not owe more than roughly $2.75 million in debt as of 2024.
- Process: Instead of liquidating assets, Alex would propose a repayment plan to pay off debts over three to five years. A trustee would oversee the plan, and Alex would make regular monthly payments to the trustee, who would distribute the money to creditors.
- Repayment Plan: The plan prioritizes payment of secured debts (like a car loan) over unsecured debts (like credit cards). After completing the repayment plan, the remaining eligible debts would be discharged.
- Outcome: Chapter 13 allows Alex to keep most of his assets while reducing debt through manageable payments. However, strict adherence to the repayment plan is required. Chapter 13 stays on Alex’s credit report for 7 years.
Which Option is Best for Alex?
- If Alex has little to no income and is overwhelmed by debt, Chapter 7 offers quick debt relief but may result in him losing some assets.
- If Alex owns a business and needs to restructure debt while keeping it afloat, Chapter 11 allows reorganization without losing everything.
- If Alex has a steady income and wants to keep most property while paying off debt (which is no more than $2.75 million) over time, Chapter 13 may offer the best solution.
As always, it’s best to consult a legal professional for individual situations, especially since state laws can vary significantly across the United States.
Students enrolled in classes at Urbana or Chicago who are concerned and want legal advice may do so by contacting student legal services for Urbana or Chicago respectively. University of Illinois Springfield does not have a student legal services unit as of fall 2024.
Challenges With Student Loans in Bankruptcy
In most cases, student loans are not automatically discharged in bankruptcy. To discharge them, you must file a separate action known as an adversary proceeding and prove undue hardship.
Consequences of Default on Student Loans
Defaulting on federal student loans can lead to:
- Wage garnishment: The government can take your wages or tax refunds to recover debt.
- Credit damage: Defaulting can severely hurt your creditworthiness.
- Collection costs: Fees from collection agencies can increase the total owed.
- Loss of additional benefits: You may be banned from future financial aid until the loans are repaid or they have been rehabilitated.
When You Can’t Repay Federal Student Loans
If struggling with federal student loan debt, Income-Driven Repayment (IDR) plans may offer relief by tying payments to your income. These plans can lower payments, but interest may still accrue.
For more information on the types of plans and other relief like deferment and forbearance available for federal student loans, contact your servicers or visit the Federal Student Aid website.
Conclusion
Bankruptcy might seem intimidating, but understanding the differences between Chapter 7, Chapter 11, and Chapter 13 can help you choose the best path if you face a financial crisis. Each type has its own rules, processes, and consequences, so it’s essential to evaluate your options carefully. For Alex, the right choice would depend on income, debt levels, and future goals.
While bankruptcy is often a last resort, it can help you take control of finances during tough times. For more information, visit official bankruptcy resources or consult a legal advisor to explore your rights and responsibilities.
References
Bankruptcy Code, 11 U.S.C. § 109(e) (2024).
Bankruptcy Code, 11 U.S.C. § 301 (2024).
Bankruptcy Code, 11 U.S.C. § 707(b) (2024).
Chapter 7 - Bankruptcy Basics. (n.d.). United States Courts. https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics
Chapter 11 - Bankruptcy Basics. (n.d.-b). United States Courts. https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics
11 U.S.C. § 523(c); Fed. R. Bankr. P. 4007(c).
11 U.S.C. § 522(b) (2024).
Chapter 13 - Bankruptcy Basics. (n.d.). United States Courts. https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-13-bankruptcy-basics
11 U.S.C. § 1322(a).(2024).
11 U.S.C. § 1322(d) (2024).
Federal Student Aid. (n.d.). https://studentaid.gov/manage-loans/forgiveness-cancellation/bankruptcy;
Student Legal Services Home. (n.d.). Student Legal Services, University of Illinois Urbana-Champaign. https://studentlegal.illinois.edu/
Student Legal Services. (n.d.). University of Illinois Chicago. https://dos.uic.edu/student-legal/
