Recently a couple from Lexington consulted with me about bankruptcy and said they didn’t want to include their mortgage or car loan. When I asked what they meant, they said they wanted to keep the home and car and could afford to keep paying the loans. As I told these clients, more often than not, this is possible in a Chapter 7 bankruptcy.
If you file bankruptcy, you must disclose all your debts. This does not mean you will quit paying every debt or that you will lose anything you own. In fact, by discharging other debts, bankruptcy can sometimes make it easier to retain such essential property.
To explain how this works, let’s look at what happens to secured debts in Chapter 7.
First of all, what is a secured debt? It is simply a debt in which the creditor, in addition to a legally enforceable promise of payment, has a lien on some item of property (called collateral) to secure the payment. In principle, the collateral could be almost anything you own.
A debt can become secured in a number of ways. The most common is when a lender, as a part of the documents financing a purchase, takes a security interest in the item purchased. Most mortgages and car loans arise this way. We refer to them as purchase money mortgages or purchase money security interests.
Other lenders, including store-front consumer finance companies like Citifinancial and American General, frequently take liens on items the borrower already owns. We call these non-purchase money security interests.
Secured debts can also arise by operation of law. For example, if someone sues you and wins the lawsuit, the resulting judgment becomes a lien on any real estate you own in that county. Other examples are tax liens, mechanics’ liens, and hospital liens.
However they arise, secured debts have one thing in common: the debt attaches to the collateral as a kind of property right and usually gives the creditor the right to have the collateral sold if the borrower does not pay the debt.
As a general rule, Chapter 7 does not cancel the liens held by secured creditors. Liens pass through the bankruptcy. When the case is done, the creditor still holds the lien. But there are a few exceptions.
The basic options in dealing with secured debts in Chapter 7 are:
(1) Avoid the lien. If a debt is secured only because the creditor has obtained a judgment or has taken a non-purchase money security interest in household goods, you may be able to cancel (“avoid”) the lien in bankruptcy and discharge the debt the same as any unsecured debt. These are the exceptions we were talking about.
(2) Retain and maintain. With mortgages on real estate, if you are current or can become current soon, you can continue making the payments and retain the home without taking any other step during your bankruptcy case.
(3) Reaffirm. With car loans and other loans secured by personal (moveable) property, you must reaffirm the debt in order to retain the collateral.
(4) Redeem. If the collateral is valued much less than the loan balance, you may be able to pay the creditor the value in satisfaction of the loan.
(5) Surrender. You may turn in the collateral, and at that point the creditor may not pursue you for any part of the debt.
When people file Chapter 7, they must indicate which of these options they will carry out. In upcoming posts, we’ll look at each of these options in more detail.