Making Sense of Bankruptcy: How Secured Debts are Treated in a Chapter 7 “Straight Bankruptcy”

Bankruptcy pays a lot of attention to and can help you deal with your secured debts in many favorable ways.

Here’s today’s sentence that we’re explaining to help you understand bankruptcy:

Filing a Chapter 7 case gives you some truly important benefits for dealing with your secured debts: protection from repossession of the collateral, writing off other debts so you can afford to pay the secured debt, excluding the secured debt from write-off through “reaffirmation,” payoff of the secured debt through “redemption,” and surrender of the collateral with write-off of any remaining debt.

The Simple, Straightforward Chapter 7 Bankruptcy

The majority of consumer bankruptcies are filed under Chapter 7 of the U.S. Bankruptcy Code.  The main relief that a Chapter 7 case provides that it discharges—writes off—your debts, and does so fast. It immediately stops repossessions, foreclosures, and virtually all other debt collection actions, and then within a few months permanently discharges all or most of your debts.

But besides getting rid of debts, Chapter 7 can help you PAY for debts that are important to you. Some of the debts that you may want to keep are secured debts.  

Secured Debts

In our last blog post we said:

A secured debt is one which is secured by collateral or a lien on an asset. Your promise to pay the debt is backed up by a “security interest”–a right that you gave to the creditor over one of your assets—your real estate or some personal property—giving to the creditor the power to take that property from you if you don’t pay the debt. Besides voluntarily giving a creditor a right to the collateral at the beginning of the transaction, a debt that is not secured by anything can involuntarily turn into a secured debt, such as when a credit card creditor files a lawsuit against you and gets a judgment lien against your home.

Besides giving you immediate protection from a creditor taking collateral or from putting a lien on something you own, Chapter 7 helps you either 1) pay a secured debt if you want to keep whatever secures that debt, or 2) stop paying the debt and surrendering the security without having to pay anything on the debt. You get to choose whether you want to keep the vehicle on the vehicle loan or the home on the mortgages, and the furniture, appliances, and electronics on the store credit cards or contracts.

Stopping Repossessions and Foreclosures

The filing of any kind of bankruptcy—including Chapter 7—imposes the “automatic stay” on all your creditors. This immediately stops all attempts by your secured creditors to take possession or ownership of your collateral or asset with a lien. This covers vehicle repossessions and home foreclosures, and also the IRS taking possession of your personal property covered by a tax lien and the county taking your real estate for unpaid property taxes.

But bankruptcy’s automatic stay not only stops already secured creditors from grabbing assets in which they already have a lien. It also prevents unsecured creditors from becoming secured ones. Examples are stopping lawsuits from turning into judgment liens on your home, and an older income tax debt from turning into a tax lien on virtually everything you own.

Being Able to Afford Your Secured Debt(s)

One of the most important benefits of bankruptcy is to relieve you from most of your debts so that you can afford to pay one or two crucial ones that you want to pay but otherwise couldn’t afford to. People file bankruptcy so that they can no longer pay other debts so that they have the money to pay their vehicle loan and not get their vehicle repossessed. Or in order to be able to afford their house payments and not risk foreclosure. Playing favorites with your creditors in this way is perfectly legal under bankruptcy law.

“Reaffirmation”

If you are current on your secured debt and want to keep the collateral, under Chapter 7 you can almost always do this. Sometimes people are concern that if they file a bankruptcy case they will not be permitted—either by the creditor or by bankruptcy law—to keep making payments on a vehicle or home. But especially if you are still current on a vehicle loan or mortgage, the creditor will be happy to keep taking your money and the bankruptcy system generally has no problem with that.  

If you do want to keep on making payments on a secured debt, you will generally need to sign a formal “reaffirmation agreement.” Just like it sounds through this agreement you are affirming that in spite of filing bankruptcy you want to continue being legally liable for this particular debt. This is necessary because otherwise the debt you want to pay (in order to keep your vehicle, home, etc.) would get discharged with the rest of your debts. In many situations this would enable the creditor to repossess the collateral, potentially even if you were current on the debt.

“Redemption”

Reaffirmations work well if you are current on the debt, and if the collateral is worth at least close to the amount of the debt. Otherwise reaffirmations are either not likely to be approved by the secured creditor or are dangerous. They are dangerous because if you agree to be legally liable on a debt secured by collateral worth much less than the debt, and later you can’t make the payments and the collateral is repossessed, you’d again owe money on a debt, after bankruptcy, with nothing to show for it.

In these situations a redemption may be more appropriate. This involves not agreeing to pay the entire debt under the original contract but rather paying a lower amount, the fair market value of the collateral, in a single lump sum payment. If you don’t have the money available to do this from any source, in many parts of the country there are enterprising lenders who make redemptions loans. Going from the original loan to a redemption one makes sense if the principle amount of the new loan is significantly lower and the rest of its terms make it feasible and worthwhile to you.

Surrender of Collateral

Chapter 7 gives you the very important option of giving up the collateral to the creditor to get out of your obligation to pay the underlying debt. This is for situations in which you do not need or want the collateral any more, or just can’t afford to make the payments.

This is an important option in bankruptcy. Surrendering collateral—especially something significant like a vehicle or real estate–is often extremely costly outside bankruptcy because of the likely “deficiency balance” that you would usually owe. That’s the remaining balance on a secured debt after the collateral is surrendered. There’s often a shockingly high balance left because the creditor usually can’t sell the surrendered collateral for much, so it’s sold for far less than the debt balance. Then after adding the auction costs and other fees are added to the debt, the final amount owed is the “deficiency balance.”

In a Chapter 7 case this deficiency balance can almost always be forever discharged, thereby making surrender of the collateral a much more sensible option.