Understanding the Different Types of Debt
All debt is not equal. Bankruptcy is a process that allows you to get rid of debt. However, different types of debt are treated differently according to bankruptcy law. So, before we go any deeper into understanding bankruptcy itself, it is important that we understand the different classes of debt and what they mean.
The two main categories of debt are secured debt and unsecured debt. It’s important to know which of your debts are secured and which are unsecured, because unsecured debt is generally better dealt with through Chapter 7 bankruptcy, whereas secured debts are usually better through Chapter 13 bankruptcy. You need to understand your own debts in order to know which bankruptcy chapter will work better for you. Let’s look at these two categories in more detail.
Secured debt means that the debt is backed by collateral. For example, the collateral for a mortgage is the home, and the collateral for a car loan is the car. Your lender has the right to seize that collateral if you fail to repay your debt as promised. That collateral - in other words, the asset backing that debt - is the lender’s “security.”
In many cases, for example on your home mortgage, you know from the start that your home is being held as collateral on the loan. However, there are other types of secured debt where it may not be so clear that something you own is actually being held as collateral.
It’s very important to understand that, with secured debt, the lender or creditor has rights both to the property that is used as collateral for the debt, and to any proceeds of its sale. If you sell any property that is used as security for a debt, and use those proceeds for any purpose other than repaying that lender, it may be seen as fraud - and debts resulting from fraud are not dischargeable through bankruptcy.
Here are some examples of secured debts.
Mortgages are the most common type of secured debt. Very few people have the means to purchase a home without borrowing money. Lenders, of course, would be reluctant to lend such large sums of money without having some sort of security or collateral on the loan. So lenders lend out the money to purchase the home, but they retain a security interest in the home itself: if the borrower does not meet their repayment terms, they can take action by seizing that home through the process of foreclosure.
That actual security interest is known as a lien. Liens work in priority. Normally your purchase mortgage is the first lien. If a second mortgage is taken out, either at the time of purchase or later, it will become the second lien. Then, say at a later date the value of your home increases by $50,000, and you want to borrow against it. That mortgage would become the third lien.
All of these loans are secured against the home. When the home is sold, they must all be paid out to the lenders before any of the funds are distributed to anyone else (including you). If the home has dropped in value, and there is not enough money to pay out all the loans, the loans are paid out according to the priority of the liens. The first lien-holder will be paid out first. If there are still funds left, the second lien-holder will be paid. Only if there are still any remaining funds will the third lien-holder receive any payment.
Vehicles and other financed Items
A car loan works the same as your home mortgage, except that usually there will only be a single lien registered against your car. The car is the collateral for the loan. If you do not repay your lender according to the specified terms, they have the right to repossess the vehicle.
Store purchase cards or revolving credit
In contrast to credit cards issued by credit card companies (which are lenders, such as MasterCard or Visa), credit issued by the seller often comes with a provision that the seller retains a security interest in the item. This is known as the seller having “lien rights” on the item.
For example, if you finance your purchase of a new television from Sears, whether that is through Sears’ revolving credit plan or through your use of a Sears’ credit card, Sears may retain lien rights on your TV. If you stop paying your loan, they may be able to repossess it. And, since your debt to Sears is a secured debt, the lien will not be removed through Chapter 7 bankruptcy - in contrast to the case of if you had purchased that TV with your MasterCard which, as a credit card, would be a unsecured debt.
Judgment liens and other nonconsensual liens
The liens we have discussed above are consensual liens: where you agree to offer the item you want to purchase as security, in order to be approved for a loan. But there are also liens that are nonconsensual, such as judgment liens.
Under certain circumstances, judgment liens may be placed on a property without the owner’s consent to secure repayment of a debt. The creditor must go to court in order to have the lien placed through a legal judgment. Examples include tax liens for unpaid taxes, mechanic’s liens for unpaid bills for work done on property or land, and judgment liens from other debts (placed by other creditors via a legal judgment). Most developments managed by a Homeowners Association (HOA) also allow for the HOA to place a lien on the property if the owner becomes delinquent on their HOA dues or fees.
Tax liens work like judgment liens, except that in some cases they automatically become the first lien, bumping any other liens (even the first mortgage) in their priority. So, for example, if you owe $20,000 in unpaid property taxes, your state taxing body could register a lien against your home to secure payment. Your first mortgage would now become the second lien, and any other junior mortgages would also be moved down the line. Sale of the home would trigger payment of the tax lien before any of the mortgages are paid out. Most income and other tax liens do not move ahead of your mortgage, however.
Homeowners Association or Condominium Owners Association liens
Most developments managed by a Homeowners Association (HOA) or Condominium Owners Association (COA) also allow for the HOA or COA to place a lien on the property if the owner becomes delinquent on their dues or fees. Some states also give “super-priority lien” status to HOA liens or COA liens where, as for tax liens, those liens may take priority over other liens provided that certain conditions are met. If your HOA or COA has placed a lien on your home, you will have to check your own state regulations.
Unsecured debt means that there is no collateral. Unsecured loans are much more risky for the lender, since there is no asset that they can seize if you do not repay it. This is why the interest rate on unsecured debts, such as credit cards, is usually higher than it is for secured debt such as mortgages.
Even though an unsecured debt has no collateral to secure payment, it can still be classified as either a “priority” or a “nonpriority” debt. Which type of debt it is makes a difference, because each is treated differently through bankruptcy.
Most unsecured debts are considered to be nonpriority debts, including:
- credit card debts
- medical debts
- certain tax debts
- personal loans
- payday loans
- overdue utility bills
- overdue rent
- overdue health club fees
- debt owing to ex-spouse from divorce or separation agreement
- debts held by collection agencies
- and any deficiency balances owing on repossessed or foreclosed items.
Nonpriority debts will usually be eliminated through bankruptcy. In Chapter 7, most if not all nonpriority debt will be completely discharged. In Chapter 13, debtors can often have their nonpriority debts discharged for only a few cents on the dollar.
Priority debts are debts that have been deemed, through the Bankruptcy Code, to be more important than other unsecured debts - either because they are debts owed to the government, or because they are debts that are considered to serve the public good. Examples of priority debts include:
- child support and spousal support
- certain income taxes
- payroll taxes
- sales taxes
- overpayment of government benefits
- criminal fines
- money owed for causing injury or death to someone as a result of operating a motor vehicle while intoxicated.
Priority debts usually cannot be discharged through bankruptcy. How priority debt is treated depends upon which chapter you file under.
Chapter 7 will require paying as much of the priority debt as sale of the assets allows for - but it will not relieve you of owing any outstanding balance. You will continue to owe any balance remaining even after the bankruptcy. Chapter 13, on the other hand, will require that you pay off your priority debts in full by the end of your five-year repayment plan.
Student loans count as unsecured debt, but there are enough unique aspects to how they are treated in bankruptcy that they merit a separate discussion.
Student loans are nonpriority unsecured debt. Up until the rewriting of the Bankruptcy Code in 2005, it was possible to discharge private student loans in bankruptcy. The new regulations make that much more difficult - but not impossible.
In order to convince the court to allow you to discharge your student loans, you must demonstrate hardship to them, by showing them that:
- as a result of the loan payments, you are not able to meet a minimal standard of living, and
- this is unlikely to change in the future, and
- you made a good faith attempt to repay the loans.
Political pressure to change how student loans are dealt with in bankruptcy has been growing for some time. We think it’s quite likely that, at some point, Congress will move to change how the Bankruptcy Code treats student loans, making them easier to discharge.
Power of creditor to object to discharge
In most cases, creditors have little choice about how monies owed to them are dealt with through bankruptcy. However, there are a few specific situations where a creditor can object to a debt being discharged.
In some cases, debts incurred in the 90 days immediately before filing bankruptcy may not be discharged. For the discharge of these debts to be disallowed, first your creditor must object to the discharge, and then the court must also agree not to discharge those specific debts. Examples of debts that may be exempt from discharge include:
- credit card purchases for goods considered to be “luxury” goods, owed to a single creditor and totaling at least $650, and incurred within 90 days before filing bankruptcy
- cash advances, owed to a single creditor and totaling at least $925, taken out with 70 days before filing bankruptcy.
The aim of this ruling is to prevent people who realize that they may soon be declaring bankruptcy from willfully taking on more debt when they know that they will not be able to repay it. If you can prove to the court that you intended to pay this money back at the time you incurred the debt, the court will likely disagree with your creditor’s claim, and allow the discharge.
There are two other categories of debt that, in some cases, are not automatically discharged through bankruptcy:
- debt obtained by fraud or under false pretences
- debt incurred through willful and malicious injury to the property of someone.
Again, in these two instances the creditor must specifically request that the court except the debt from discharge, and the court must agree with the request.
Keeping some debt outside of the bankruptcy
Why would anyone want to keep some debts if you are filing bankruptcy? In some cases, debtors owe money to friends or family, and they would like to keep that debt outside of the bankruptcy, because they intend to repay it later to maintain good relations or their good reputation. In other cases, people don’t want to have to give up their credit card by including the balance owing in the bankruptcy.
The bottom line, though, is that you cannot choose to keep certain debts out of the bankruptcy. If you have a balance owing, you are required by law to list it.
You cannot choose to keep certain debts outside of the bankruptcy - and in most cases it is not in your best interest to do so anyway. As far as credit cards go, you do have the option of reaffirming your debt with the credit card company so you can keep your card (which means that you keep that debt outside the bankruptcy and sign a new agreement with your credit card company to repay it). However, in nearly every case, it is much more advantageous to have that debt wiped out, and to work from a clean slate to re-qualify for a new credit card instead.
As far as debt to friends or family goes, bankruptcy will legally wipe out your obligation to repay that debt. However, you can choose to repay any debt that you want to after the bankruptcy anyway. So you can still maintain good relations with your friends and family and repay that debt even though it was “officially” discharged through the bankruptcy. But you must first list it in the bankruptcy petition along with all of your other debts.
Preferential treatment of some debts prior to filing bankruptcy
You should be very cautious about paying off debts in the 90 days leading up to filing bankruptcy. For example, if you rush to pay your credit card, so you can get your balance down to zero and not include the credit card in the bankruptcy, the court will likely see that as preferential treatment to one creditor. Chances are that the trustee will seek to recover those funds, so they are proportionately distributed to all of your creditors.
And the same goes for money owed to friends or family - except that the court will look back even further. Any funds you have repaid to friends or family in the entire year preceding the bankruptcy will be scrutinized, and if it appears that you have preferentially paid them before other creditors, those funds also may be recovered to distribute fairly to all creditors.
Read on for our next article in this series: Personal Decisions About Bankruptcy