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Secured Debt Treated Like Unsecured Debt after Collateral Surrender

A secured debt effectively turns into an unsecured debt if you surrender the collateral, which may make sense to do more than you think.

“General Unsecured” Debts and Secured Debts

Our last blog posts described the huge difference in the treatment of “general unsecured” and secured debts in bankruptcy. “General unsecured” debts are discharged—legally and permanently written off. But with secured debts, the lien that the creditor has in something you own is not usually affected in bankruptcy. The lien continues in effect, giving the creditor continued rights to your asset after the bankruptcy case is completed, including usually the right to repossess or foreclose. So if you want to keep that asset, usually you have to pay the debt.

However, last time we listed 3 situations in which bankruptcy effectively turns a secured debt into an unsecured one. We focus on the first of those situations today.

Surrendering the Asset

Simply giving the asset in which a creditor has a lien to that creditor essentially turns the debt into an unsecured one. As far as you’re concerned the debt’s no longer secured. The creditor no longer has a lien in anything you own, and so has no leverage over you.

You can now discharge the debt and pay nothing on it.

When to Surrender the Asset to the Creditor

There are more circumstances than you might think when your best option is to give the asset to the creditor.

1. You can’t afford the payments.

It’s worth taking a very honest look at how much filing bankruptcy is going to help your monthly cash flow. You may absolutely need bankruptcy relief to deal with unbearable debt pressures. And the minute you file your case, you most likely will be able to stop paying a lot of monthly debts. That may free up money so you can then comfortably pay your vehicle loan or home mortgage payment.

But be careful. Especially if you’ve not been paying many of your debts for a while, filing bankruptcy may not free up as much disposable income as you think. Pay close attention when your bankruptcy lawyer helps you put together a formal budget. (See Schedule I & Schedule J.) Be very honest with yourself about whether you will really be able to afford to make the secured debt payments. If it’s iffy, seriously consider whether surrendering the vehicle or home and owing nothing might be your better choice.

2. You are behind on the payments and filing a Chapter 13 case is not worthwhile.

If you’ve fallen behind on your vehicle loan or home mortgage, you usually have very little time to catch up in a Chapter 7 “straight bankruptcy” case. Chapter 13 “adjustment of debts” gives you much more time, often as much as 5 years. But consider carefully whether keeping the vehicle or home is worth the downsides of a Chapter 13 case.

For various reasons Chapter 13 cases have a much lower successful completion rate than Chapter 7 ones. You can struggle to fulfill the obligations of your Chapter 13 payment plan for several years, only to end up not succeeding. At that point you may have to surrender your home or vehicle after all. And/or you may need to convert your case into a Chapter 7 one, after a lot of wasted effort. In the meantime you’ve made little or no progress on improving your credit score. More importantly, you’ve delayed the emotional fresh financial start that you really need.

So use the strong medicine of Chapter 13 to cure your financial ills. But avoid it when it’s likely to instead bring you these kinds of adverse side effects.

3. Even if you are not behind or can catch up fast, it’s just not economically worth keeping the asset.

There’s more to life than economic calculations. Sometimes there are valid intangible reasons making it worth fighting hard to keep a vehicle or a home even if it has no equity. Your vehicle may well be worth much more to you than some generic “blue book” dollar amount. The stability of a home, either for yourself, your marriage, or your kids, can have huge genuine value.

On the other hand be very careful about putting too much weight on these kinds of intangibles. A sensible rule of thumb to think about is whether you can honestly and dispassionately consider the option of surrender. If you refuse to even consider other alternatives, that’s a warning sign that you maybe you’re not being realistic. If it’s very clearly a financially bad idea to sink more money and time into something, you need to at least seriously consider other options.  

4. It’s risky down the line to keep the asset, so take advantage of your right to discharge the debt now.

Especially with vehicles, you often have a virtual once-in –a-lifetime opportunity to get out of a bad loan when you file a Chapter 7 bankruptcy case. Almost always you have to “reaffirm” the debt if you want to keep the vehicle. That means that you legally exclude the vehicle loan from the discharge of your other debts. You have to choose one or the other: surrender the vehicle and discharge the debt, or keep it and not discharge the debt.

If you keep the vehicle and reaffirm the loan, and then months or even years later you can’t make the payments and the vehicle is repossessed, you could easily end up owing a lot of money. You’d have no vehicle and you’d owe the money. Months or years after your Chapter 7 case you’d be in financial trouble again. So carefully consider whether you will be able to keep up payments on a secured debt in the long run. Think about whether it’s wiser to surrender the vehicle/home (or other collateral) and get a fuller fresh start now.  

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