The Most Basic Concept in Bankruptcy: Debts
The most practical questions you likely have if you are considering bankruptcy is what it will do to each of your debts. Will you still owe anything to anybody? What about debts you want to keep like a vehicle loan or mortgage? How to handle special debts like income taxes and child support?
To understand bankruptcy you need to understand debts. One of the most basic principles of bankruptcy is that it treats all creditors in the same legal category the same as all the other creditors in that category. So the first step in understanding debts is to understand the three main categories of debts. Not everybody has debts in each of these categories, but lots of people do. At the end of this blog, you should be able to at least start dividing your debts among these three categories. From there, bankruptcy and how it deals with each of your creditors will start making more sense.
The three categories are “general unsecured debt,” “secured debt,” and “priority debt.”
All debts are either secured by collateral or not. Whether or not a debt is secured is often very straightforward, such as with a vehicle loan in which the vehicle’s title specifies your lender as the lienholder. That lien on the title, together with the documents you signed with that lender, gives that lender certain rights as to that collateral, such as the right to repossess it if you fail to make payments.
In the case of every secured debt, there is a legally prescribed way to attach the debt’s collateral to the debt. In the case of the vehicle loan, the lender and you have to jump through certain hoops for the lender to become a lienholder on the title. If those aren’t done right, the vehicle might not attach as collateral to your loan.
Debts can be fully secured or only partially secured. If you owe $10,000 on a vehicle worth only $8,000, the debt is only partially secured—secured as to $8,000, and unsecured as to the remaining $2,000 of the debt.
Debts can be voluntarily or involuntarily secured. Examples of the latter are judgment liens on your home, IRS income tax liens on all your personal property, and a mechanic’s or repairman’s lien on a vehicle that’s been repaired and the repair bill not paid.
General Unsecured Debts
All debts that are not legally secured by collateral are simply unsecured debt. And “general” unsecured debts are simply those which do not belong to any of the categories of “priority” debts (discussed below). So general unsecured debts are the default category—if a debt is not secured and not a priority debt, it’s a general unsecured one. They include every imaginable type of debt or claim. Common ones include most credit cards, essentially all medical bills, personal loans without any collateral, bounced checks, most payday loans (although those sometimes have collateral), unpaid rent and utilities, balances left over after a vehicle is repossessed, many personal loans, and uninsured or underinsured motor accident claims against you.
Sometimes debts which were previously secured can become general unsecured ones, and vice versa. An example of the first: once you’ve surrendered all the collateral—such as a vehicle on a vehicle loan—any remaining debt is general unsecured. And an example of the second: a general unsecured medical bill can become secured after a lawsuit is filed against you and a judgment entered, resulting in a judgment lien attached to your real estate.
Just like it sounds, priority debts are special ones that the law has selected to be treated better than general unsecured debts. In fact, there are very specific levels of priority among all the priority debts.
It’s all about who gets paid first (which often means who gets paid at all). This comes up in two main ways.
First, most Chapter 7 cases don’t involve the trustee receiving any of your assets for distribution to your creditors. But in those cases where there are non-exempt assets, the priority creditors are paid in full before the general unsecured ones receive anything. And the higher priority creditors are paid in full before the lower priority ones.
Second, in a Chapter 13 case, your formal plan has to show that you will pay all priority debts before the completion of your case, and then you must in fact do so before you are allowed to finish it.
The most common priority debts for consumers or small business owners are the following, in order starting from the highest priority:
• child and spousal support—amounts owed as of the time of the filing of the bankruptcy case
• the administrative costs of the bankruptcy case—trustee fees and costs, and in some cases attorney fees
• wages and other forms of compensation owed to employees—maximum of $10,000 per employee, for work done in the final 180 days before the bankruptcy filing or close of business, whichever was first
• certain income taxes, and some other kinds of taxes—some are priority but others are general unsecured if they are old enough and meet some other conditions
In the next blog I’ll get more into how debts in each category are treated in Chapter 7 and Chapter 13.