Can Secured Debt Be Discharged in Bankruptcy?

Can Secured Debts Be Discharged in Bankruptcy?

Secured debts are unique because they’re tied to collateral, like a car or home. Here’s how secured debts are treated in Chapter 7 and Chapter 13 bankruptcy.

How Secured Debts Work in Chapter 7

Yes, secured debts can be discharged in Chapter 7 bankruptcy, but it works differently than with unsecured debts. A Chapter 7 discharge wipes out your personal liability for the secured debt, meaning the lender can’t come after you for unpaid amounts after your discharge. However, because secured debts are tied to collateral — like a car or house — you’ll need to pay the debt if you want to keep the collateral.

If you can’t or don’t want to keep paying the secured debt, you have the option to surrender the collateral. This means you give the property back to the lender, and you’re no longer responsible for the debt. If you want to keep the collateral, you may need to reaffirm the debt, which means agreeing to continue paying it even after your bankruptcy discharge.

How Secured Debts Work in Chapter 13

In Chapter 13 bankruptcy, secured debts are handled through your repayment plan. You’ll pay back these debts over three to five years, usually at a lower monthly payment amount. This can make keeping your home, car, or other collateral more manageable.

If you decide you don’t want to keep the collateral, you can surrender it during the bankruptcy case. Once the collateral is surrendered, you’re no longer responsible for the remaining debt balance. Chapter 13 is often a good option for people who need time to catch up on payments to keep important secured property, like a family home.

Secured vs. Unsecured Debts: What's the Difference?

Secured debts are tied to collateral, which is something of value, like a car or home, that the lender can take if you don’t pay. When you take out a loan for a car or home, you sign a security agreement that gives the lender the right to repossess the collateral if you stop making payments. Secured debts are commonly used to finance purchases like vehicles, furniture, or appliances, but sometimes they’re backed by property you already own, like with a title loan.

Unsecured debts, on the other hand, don’t have any collateral backing them. This means the lender can’t repossess anything if you fail to pay, though they may sue you to try to collect. There are a lot of different types of unsecured debt, including credit card debt, medical bills, personal loans, and old utility bills. Student loans are also unsecured debts but they're treated a little differently in bankruptcy.

When you file for bankruptcy, a discharge order eliminates your personal responsibility for certain debts. Unsecured debts are typically easier to discharge, meaning you no longer owe them. Secured debts, however, work differently because they’re tied to collateral. If you want to keep the collateral, you must continue paying for it even after bankruptcy.

What Type of Debt Can Be Discharged in Bankruptcy?

Aside from a few exceptions listed below, most unsecured debt can be discharged in bankruptcy. Chapter 7 bankruptcy eliminates unsecured debts completely and quickly. A typical Chapter 7 case only takes about four to six months from start to finish. Chapter 13 bankruptcy, on the other hand, involves a repayment plan that lasts from three to five years. Depending on your income and expenses, you may pay some or all of your unsecured debts through your Chapter 13 plan. When you complete your plan, any remaining unsecured debt is discharged.

Secured debt can also be discharged in bankruptcy. But, as explained below, discharge is more complicated when it comes to secured debt.

What Debts Can’t Be Discharged in Bankruptcy?

Bankruptcy law specifies that certain types of debts can’t be discharged in bankruptcy. Some of these nondischargeable debts include:

• Debt resulting from misconduct: For example, if you hit someone while driving under the influence, any resulting debt — such as a criminal fine, restitution, or a personal injury lawsuit — isn’t dischargeable.

• Domestic support obligations: Such as child support or alimony.

• Certain types of tax debt and other debt owed to the government: The Bankruptcy Code has a complicated formula to determine whether income taxes are dischargeable, but recent tax debt usually isn’t. Many government fines and fees also can’t be discharged.

Some kinds of debt can’t be discharged in Chapter 7 bankruptcy, but can be discharged in Chapter 13 bankruptcy. Some examples include:

• Some divorce-related debt (not including child support or alimony)

• Debt resulting from intentional damage to property

• Debt incurred to pay a non-dischargeable tax debt

How Secured Debt Works in Bankruptcy

Secured debt works differently in bankruptcy because it’s tied to both property (collateral) and your personal obligation to repay the loan. These two parts — the lien on the property and your responsibility to pay — are separate and can be affected differently by bankruptcy.

Secured Debt Is Connected to Both You and the Property

When you borrow money to buy something like a car or a house, the loan is secured by the item you’re buying. The lender places a lien on the property, which gives them the legal right to take it back if you don’t make payments. For example, if you take out a car loan, the lender can repossess the car if you fall behind on payments.

At the same time, you’re personally responsible for the debt. This means the lender can hold you accountable for paying it off, even if the collateral is sold or repossessed. They may also report the debt to the credit bureaus, which can impact your credit score.

Bankruptcy Can Wipe Out Your Responsibility, but Not Always the Lien

Here’s where bankruptcy gets a little tricky. In many cases, a bankruptcy discharge can eliminate your personal responsibility for secured debt, so the lender can’t sue you for unpaid amounts. However, the lien on the property doesn’t automatically go away. The lender can still take back the collateral if you stop making payments.

Repossessed Car Example: Say your car is repossessed, and the lender sells it for less than what you owe. The remaining amount is called a deficiency balance, and you’re still responsible for paying it. Bankruptcy can erase your obligation to pay the deficiency balance, but the lender already has the car, so the lien is no longer relevant.

On the other hand, if you still have the car and want to keep it, you’ll need to keep paying the loan even after the discharge, or the lender can repossess it.

What Happens to Secured Debt in Chapter 7?

In Chapter 7 bankruptcy, the bankruptcy trustee can sell your belongings and use the money to pay your creditors. This is called liquidation. But there are exemption laws that protect some or all of your property from being liquidated. In most Chapter 7 cases, the trustee doesn’t liquidate anything because all the debtor’s assets are exempt.

In other words, in Chapter 7, you can usually keep the car, furniture, or other collateral you’re using secured debt to finance. The debt attached to secured property means you have less equity in that property, so it’s more likely to be protected by exemptions.

If the collateral is exempt, you can keep it. But you’ll still have to pay for it, even after the secured debt is discharged. Let’s go back to Bob and his car to examine how this works.

• Example 2 – Chapter 7 Discharge: Bob files Chapter 7 bankruptcy and gets a discharge. The discharge order wipes out Bob’s personal liability for his car loan, so the debt is no longer attached to Bob. But the debt is still attached to Bob’s car. The discharge order doesn’t wipe out the lender’s security interest.

In this example, Bob must keep paying his car loan if he wants to keep his car, even after his bankruptcy discharge. The loan debt is still attached to his car. If Bob doesn’t pay, the lender can still repossess the car. But once that car is no longer Bob’s car (because of the repossession), the debt is no longer Bob’s problem. It was only attached to the car. The lender can’t collect a deficiency balance from Bob because the discharge wiped out Bob’s personal liability for the debt.

To keep collateral in Chapter 7, you must usually be current on your payments. Your lender may also require you to sign a reaffirmation agreement.

What Is a Reaffirmation Agreement?

A reaffirmation agreement is an agreement between you and your lender that both of you will still have the same rights and obligations after the bankruptcy as you had before. When you reaffirm a secured debt, that debt is excluded from your bankruptcy discharge. After your bankruptcy, the debt is still attached to both you and to the collateral. To be valid, a reaffirmation agreement must be approved by the bankruptcy judge.

Do you have to sign a reaffirmation agreement if you want to keep the collateral? It depends on your lender.

In Example 2 above, Bob didn’t reaffirm his car loan. If he had, the loan debt would still be attached to both Bob and his car, even after the bankruptcy. Like Bob, many Chapter 7 debtors keep their cars after bankruptcy without reaffirming the debt. You might choose not to reaffirm a debt to avoid a potential deficiency balance in the future. Or you might not be able to reaffirm a debt because of your finances — the judge won’t approve a reaffirmation agreement if your paperwork shows you can’t afford the ongoing payments.

Some lenders require you to enter a reaffirmation agreement to keep the collateral. These lenders will repossess the collateral if you don’t reaffirm the debt, even if your payments are current. This is legal because the discharge eliminates your personal attachment to the debt. Wiping out this attachment also wipes out some of the rights and protections that were contained in your original contract with the lender.

Most lenders, though, would rather have your payments than spend the time and money repossessing the collateral. These lenders typically allow you to keep the collateral and keep paying the loan after your bankruptcy, even without a reaffirmation agreement.

What Does It Mean To Surrender Collateral?

If you have secured debt, you’re not required to keep the collateral, even if it’s exempt. Bankruptcy gives you the option to surrender the collateral and walk away from the debt. Some reasons you might consider this option:

• You can’t afford the ongoing loan payments or you’re behind on the payments.

• The loan has a high interest rate.

• The collateral is damaged and you can’t afford to repair it.

• You owe more on the loan than the collateral is worth.

When you choose to surrender collateral through bankruptcy, your lender must accept this choice. When you legally give up your right to the collateral, the debt becomes unsecured. It’s treated like any other debt that isn’t secured by collateral. A Chapter 7 bankruptcy discharge usually wipes out your unsecured debts.

What Happens to Secured Debt in Chapter 13?

Chapter 13 bankruptcy gives you more options for dealing with secured debt than Chapter 7. You can surrender the collateral and walk away, just like in Chapter 7. If you want to keep the collateral, you’ll usually pay the debt through the Chapter 13 repayment plan. This plan lasts from three to five years. You make plan payments to the Chapter 13 trustee, and the trustee pays your creditors according to the plan terms. When you complete all the plan payments, the court enters a discharge order.

Through the Chapter 13 plan, the bankruptcy court has the power to adjust the loan’s payment term and reduce the interest rate. If the loan balance is more than the collateral is worth, the court can reduce the loan balance to match the value of the collateral. The part of the debt that exceeds the collateral’s value becomes unsecured debt. Secured creditors are ordered by the bankruptcy court to accept the terms of your Chapter 13 plan.

• Example 3 – Chapter 13 Plan:

  Bob is behind on his car loan. The loan balance is $18,000. The market value of Bob’s car is $10,000. Bob files Chapter 13 bankruptcy. The court reduces the loan balance to $10,000 to match the car’s value. The other $8,000 becomes unsecured debt. The court also reduces the interest rate. Through his Chapter 13 plan, Bob pays the $10,000 balance at the reduced interest rate over a three-year term. He also pays $800 of the unsecured portion. The other $7,200 of the unsecured portion is discharged at the end of Bob’s plan.

Also, unlike Chapter 7, in Chapter 13 you can keep the collateral even if you’re behind on the payments. For most secured debts, once the court has adjusted the debt as described above, you pay the adjusted balance in full through the Chapter 13 plan. Since you’re effectively refinancing the whole debt, it doesn’t matter that you were behind under the original contract terms.

The rules for real estate loans are different from loans secured by personal property. Most people can’t pay off their mortgage in full within a 3-5 year plan. If you’re behind on your mortgage and file Chapter 13, then each month you’ll pay your regular house payment plus a portion of the past-due amount. You make these payments through the Chapter 13 trustee. Also, unlike other secured debts, bankruptcy law doesn’t allow the court to reduce your mortgage balance to match the value of the property.

At the end of your plan, the Chapter 13 discharge eliminates any remaining unsecured debts that weren’t paid through the plan. This includes the unsecured portion of any secured debt. Since your secured debt was paid in full through the plan, there isn’t any remaining secured loan debt attached to either you or to the collateral.

Let’s Summarize…

Secured debts can be discharged in bankruptcy, but that doesn’t mean you get to keep the collateral for free. Most secured debt in Chapter 7 is discharged unless you reaffirm the debt. Even though the Chapter 7 discharge wipes out your personal liability for the debt, the debt is still attached to the collateral. You must pay the debt if you want to keep the collateral, even after bankruptcy.

Most secured debt in Chapter 13 is paid through the Chapter 13 plan, so there’s no debt attached to you or your collateral when the discharge is entered. In both kinds of bankruptcy, you have the right to surrender the collateral. If you do, the debt is no longer secured.