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Bankruptcy doesn't treat all debts the same way. Knowing the differences between priority and non-priority debts can help you understand how the process will address your financial obligations—and why it may not eliminate all of them.
Federal bankruptcy procedures are designed to protect individuals overwhelmed with debt and in need of a fresh start. Bankruptcy can bring relief from anxiety and bill collectors, but it comes at a heavy cost: It may require forfeiture of personal property or other assets, and it always causes lasting harm to personal credit.
In exchange, bankruptcy typically leads to the cancellation of most, if not all, of your outstanding debt. There are certain categories of debt, called priority debts, that cannot be cancelled, or discharged, in the course of bankruptcy, however. Understanding the difference between priority debts and non-priority debts in different bankruptcy procedures can help you decide whether filing for bankruptcy makes sense for you.
Chapter 7 vs. Chapter 13 Bankruptcy
U.S. law allows for two different types of individual bankruptcy procedures: Chapter 7 (also known as liquidation bankruptcy) and Chapter 13 (reorganization bankruptcy). If you file Chapter 7 bankruptcy, most of your assets will be sold off or otherwise liquidated and the proceeds used to pay your creditors. Chapter 7 filers' assets typically amount to less than their total debt.
If you file Chapter 13 bankruptcy, the court devises a debt reorganization plan, typically lasting five years, during which you must make repayments that are divided among your creditors. A Chapter 13 repayment plan protects you from making payments you cannot afford, which typically means creditors receive less than the full amount you owe them.
In either a Chapter 7 or a Chapter 13 case, because there is typically less money available to repay all creditors in full, it falls to the bankruptcy court to sort out which of your creditors get paid and how much, based on the amount of funds available. That's where the priority and non-priority distinction comes in.
The Difference Between Priority and Non-Priority Unsecured Debts
In a bankruptcy proceeding, the judge, in coordination with a court-appointed trustee, prioritizes the bankruptcy filer's outstanding debts. Claims by creditors—companies and individuals owed money by the person filing for bankruptcy—are reviewed by the court and ranked according to their significance.
Priority debts are considered so important under federal bankruptcy law that they must be addressed before all competing claims. These include:
- Child support
- Criminal fines
- Unpaid federal income tax obligations less than three years old (and sometimes older)
- Federally backed student loans. These are a special case of priority debt: They cannot be discharged automatically through bankruptcy like non-priority debts, but pursuing a separate procedure called an "adversary proceeding" in conjunction with a bankruptcy filing may allow them to be discharged. Having student loan debt discharged in this manner requires you to prove that you made a good faith effort to pay the loan and that you or your dependents will suffer hardship if you are compelled to repay the loan. In contrast to regular bankruptcy procedures, in which creditors are not present in court, representatives of the lender may appear at an adversary proceeding to challenge your claims.
Non-priority debts include the bulk of unsecured debts, such as:
- Past-due credit card bills and outstanding credit card balances
- Unpaid personal loan payments
- Private debts to friends and family members
- Overdue bills, including those for rent, utilities and cellphones
Secured Debts and Bankruptcy
Many secured debts, such as auto loans and mortgages, in which the lender retains a claim on purchased property until the loan is paid off, are considered non-priority debts under bankruptcy law. A bankruptcy court may discharge your obligation to pay overdue payments on a secured debt, but the lender may still seize and sell the property in accordance with the original loan agreement.
If you file Chapter 13 bankruptcy, the court-imposed repayment plan may allow you to make up for past-due payments on a secured loan, allowing you to retain the property as long as you keep up with future payments (or arrange to buy the property outright in a lump-sum payment).
How Do Priority Unsecured Debts Work in Chapter 13 and Chapter 7 Bankruptcy?
In a Chapter 7 bankruptcy, if there are sufficient funds to repay any debts, creditors with stronger claims receive payment ahead of those with weaker claims. In a Chapter 13 bankruptcy, creditors with stronger claims may receive a higher percentage of what's owed them than those with weaker claims.
When the bankruptcy filer's assets are sold off in a Chapter 7 bankruptcy, proceeds must be put toward priority debts before other creditors receive any payment. When a debt repayment plan is devised in a Chapter 13 bankruptcy, creditors with priority debts typically must be paid in full, while those with non-priority debts may have to accept partial payment.
Whether you file for Chapter 7 or Chapter 13 bankruptcy, when the process concludes and you've fulfilled the court's requirements, most of the debts that remain unpaid are considered discharged: You are no longer responsible for them, and creditors may no longer bring suit against you or otherwise attempt to collect them. Priority debts cannot be discharged, however, and you'll remain responsible for repaying them even after other debts have been set aside.
How Does Bankruptcy Affect Your Credit?
A bankruptcy filing is considered a major negative event in your credit history, and it typically has a long-lasting negative impact on your credit score. Chapter 7 bankruptcies remain on your credit report for 10 years from the filing date, while Chapter 13 bankruptcies stay on your credit report for seven years.
Filing for bankruptcy typically causes a significant drop in credit score. The number of points by which your score will drop depends on the score you have when the bankruptcy appears on your credit report. Individuals often file for bankruptcy after missing multiple loan payments, and sometimes after defaulting on loans or incurring property foreclosures—all events that can significantly lower credit scores. The cumulative effect of those events may cause a large enough reduction in credit score that a bankruptcy filing itself might not decrease scores very much.
That said, a Chapter 7 bankruptcy stays on your credit report, and hurts your credit score, longer than any other negative event. Credit scores do begin to rebound in the years following a bankruptcy filing, but many lenders refuse to consider loan applicants with bankruptcies on their credit reports, regardless of their credit scores.
Filing for bankruptcy is a decision that should never be taken lightly. If you're considering it, and pondering whether to file Chapter 7 or Chapter 13, it can be helpful to review your debts to understand which are priority debts and which are non-priority, and which can and cannot be discharged. Consulting with legal and financial experts can help you understand the difference, and anticipate where you'll stand if you decide to move forward with a bankruptcy.