When a bankruptcy case is filed, the various types of debts are classified into various categories: secured, priority unsecured, general unsecured, or administrative claims. This post will discuss secured debts and how they are often treated in a bankruptcy case. What is a secured debt? A secured debt is a debt in which the lender has some sort of collateral as a “security” for a loan.
In other words, the lender has the ability to repossess some collateral if the debt is not paid. Typical secured debts are home loans, car loans, boat loans, and furniture loans. In order for a creditor to claim secured status, they are required to do certain technical things, such as record their lien, and do a few other things.
With an unsecured debt, there is no collateral. Even though a secured loan may be discharged in a bankruptcy (wiped out), the lender will normally retain the ability to repossess the collateral. (There are exceptions to this, however. Liens can be, and are, stripped away in certain situations in a bankruptcy).
If a lien is not stripped away in a bankruptcy (this can be done under certain conditions), or if it is not being “crammed down” in a Chapter 13 or Chapter 11 case, a secured loan typically is handled in a few ways. One option is for the debtor simply to surrender (i.e., turn over) the collateral back to the lender. Once this happens, any remaining loan balance is normally wiped out in the bankruptcy. Many creditors do not like repossessing collateral. Used things normally drop significantly in value, and creditors do not enjoy having to deal with equipment or merchandise. But they have no choice in the matter. A debtor has the right to surrender collateral if she or he wants to in the case.
Another option, which is not very often used, is the option to “redeem” the collateral. For example, if someone has a vehicle with a fair market value of $5000, but has a loan against it for $9500, a debtor can “redeem” the car and own it free and clear by paying the creditor the market value ($5000) for a lien release. Many debtors do not have access to the disposable cash to enable them to do this. So, understandably, this option is not seen very often.
A third option is the option of “reaffirming” the secured loan. This is done by signing a reaffirmation agreement with a secured creditor. Although the secured loan is technically discharged in the bankruptcy, a reaffirmation agreement is a written contract that a debtor can sign with the creditor after the bankruptcy is filed. The debtor agrees to give up one of the rights he has in the bankruptcy, which is the right to have the debt discharged. This means that if the collateral is ever repossessed or foreclosed on in the future, the creditor will be able to sue the debtor for the deficiency on the loan. Naturally, creditors love reaffirmation agreements. However, what is in the creditor’s interest is rarely in a debtor’s interest. This agreements should only be signed in very specific circumstances, with a full understanding of what the debtor is giving up. For most people, signing them is not a good idea.
Although it is not an official option under the bankruptcy code, many debtors elect to continue to “retain and pay” on the secured loan if the creditor consents to it. The vast majority of creditors do consent to this arrangement. A thinking creditor would much rather have a debtor’s monthly payments than have to repossess some collateral that is worth far less than the amount of the loan.