Secured or Unsecured? Why it Matters

In bankruptcy, not all debt is created equal. How a debt is treated in bankruptcy depends on various factors, primarily (1) the classification of the debt and (2) the chapter of the bankruptcy code under which the case is filed. The majority of debtors filing for bankruptcy file under Chapter 7 or Chapter 13. Within these two chapters of the Federal Bankruptcy Code, there are three major classifications of debt of which consumers and debtors should be aware.

Secured Debt

Simply put, secured debt is debt that is backed by collateral. If a creditor has a lien against your property, such as a home you have purchased, then this debt is considered secured and is sometimes referred to as a “security interest.” Although there are many types of secured debts, the most common examples are homes and cars. Secured creditors have greater rights in bankruptcy because their liens are “secured” by the collateral, and these greater rights exist regardless of the chapter under which a debtor files.

What does having a “secured’ creditor with “secured” debt through a “security interest” mean for debtors? Under a Chapter7 bankruptcy, a successful and complete bankruptcy discharges the debtor of personal liability for secured debts; however, and most importantly, the secured creditor still retains the security interest in the debtor’s property. Because a secured creditor still has a security interest in the debtor’s property even after the debt has been discharged by bankruptcy, this means that if a debtor wishes to keep that specific piece of collateral property through and after a Chapter 7 bankruptcy, the debtor has the option to keep the property, but only if the debtor continues making monthly payments on that debt. If a debtor subsequently defaults on or fails to make these payments in an attempt to retain the collateralized property, the secured creditor may exercise the right to repossess or foreclose on that collateralized property. However, in an effort to protect debtors, bankruptcy limits the creditor’s ability to recover or repossess collateral. After a creditor repossesses or forecloses on secured collateral in a Chapter 7 bankruptcy, the secured creditor is then barred from seeking any leftover or additional payments from the debtor.

Here is an example of how this works practically. If Sally owns a car and files Chapter 7 bankruptcy, she has the option to keep her car if she is current on her payments and states in her bankruptcy petition that her intention is to retain her car and continue making her normal monthly payments. If Sally defaulted on her car payments prior to filing and is not current on her payments, her car would be subject to repossession by her creditor. However, her creditor’s ability to collect the debt is limited to repossession because Sally’s loan on her car and her responsibility to pay that loan is discharged through bankruptcy. This means that a creditor is only able to recover the value of the car. For instance, if Sally owes a total of $30,000 on her loan and the car is repossessed by her creditor and sold at auction for only $15,000, her creditor is barred from attempting to collect the remaining $15,000 balance on the loan from Sally because Sally’s obligation to pay the remaining balance is discharged in bankruptcy.

If a debtor has defaulted on home or car payments and still wishes to keep that property, she may choose to file a Chapter 13. In a Chapter 13 bankruptcy, a debtor may combine all of his debts into one monthly payment and will be put on either a three-year or five-year payment plan for this consistent monthly amount. To successfully confirm and complete a Chapter 13 plan, a debtor must be able to pay all secured debtors fully through his plan payments. If a debtor is unable to pay the secured debts in full on this payment plan, then his Chapter 13 case will be dismissed by the Court.

Priority Debt

Priority debts are debts not secured by collateral, but are generally non-dischargeable in bankruptcy, meaning debtors are still going to have to pay these debts throughout their bankruptcy filing. Common examples of priority debts include domestic support obligations, such as alimony and child support, and any taxes owed to the government.

If a debtor files a Chapter 7, priority debts are considered non-dischargeable, leaving the debtor still liable for those payments even after the conclusion of the case. In order for a debtor to obtain a Chapter 13 bankruptcy plan confirmation, a debtor must show that he or she can pay all priority debts in full.

General Unsecured Debt

General unsecured debts are not secured by collateral and are not backed or collateralized by any piece of property, and have no priority granted to them under the Bankruptcy Code. Common examples of general unsecured debts are personal loans, credit card payments, and medical debt.

Under a Chapter 7 bankruptcy, any unsecured debt is wiped out once a debtor completes the Chapter 7 bankruptcy process and gets a discharge. This means any creditors with unsecured debt cannot go after the debtor for those unsecured debts. Under a Chapter 13 plan, general unsecured creditors are only paid with any money that is leftover after funds have been distributed to the secured and priority creditors. Depending on the Chapter 13 plans, general unsecured debtors receive full distribution, no distribution, or pennies on the dollar. Practically speaking, unsecured debts receive the smallest distribution of any category of creditor in bankruptcy, but a bankruptcy discharge will protect debtors from unsecured creditors’ attempts to collect on any unsecured debt.

It is important for any debtor, one who is considering bankruptcy or not, to be aware of the different types of debts she may have. The type of debt you have, along with the chapter of bankruptcy under which you file, will impact how your bankruptcy proceeds as well as the remedies your creditors have against you. If you are a debtor struggling to make payments on any kinds of debt, give our firm a call for a free consultation today!