Chapter 7 Gives You Power Over Your Secured Creditors

Law Office of Robert L. Firth May 25, 2015

Your secured debts are the most dangerous because the creditors can take your collateral. Chapter 7 improves your options with them.

How Debts Become Secured Debts

A secured debt is usually one in which your agreement to pay that debt is backed up with some collateral. You give the creditor a “security interest” in something you own (sometimes the thing you are buying on credit). So if you don’t pay the debt, the creditor can take possession and ownership of that collateral. For example, if you don’t pay your debts a mortgage lender can foreclose on your home or an appliance store can haul away your washer and dryer.

But in order for a creditor to have a “security interest” in your collateral—and to be able to repossess if you don’t pay—the creditor must have initially gone through the appropriate legal steps to tie the collateral to the debt. Some debts that appear to be secured debts are not. In the above example of the washer and dryer, whether or not the creditor can repossess your appliances depends on whether it you gave it that right in the contract and whether the creditor followed all the required legal steps.

Note that there are also secured debts in which a creditor would have a “security interest” to something you own not because you agreed to it but instead because the creditor got its rights by operation of law. For example, the IRS has the legal right to record a tax lien against your real estate and/or personal property if you don’t pay your income taxes.

The Powers Over Secured Debts from Filing a Chapter 7 Case

Filing a Chapter 7 “straight bankruptcy” case will:

  1. stop your creditor—temporarily or permanently—from taking your collateral;

  2. help you keep the collateral; and

  3. if you chose, let you to surrender the collateral to the creditor without owing anything more on the debt.

Power # 1: Prevent the Creditor from Taking the Collateral

When your Chapter 7 case is filed, all your secured creditors are immediately stopped from taking possession of whatever you own that secures the debts. This protection is the “automatic stay,” the same federal law that stops virtually all collection activity by all your creditors again you and everything you own.

Not only does the “automatic stay” stop secured creditors from taking away your property in which it has a “security interest.” The “automatic stay” can also stop creditors which do not have a “security interest” in anything from getting one in something you own free and clear. For example, after filing a bankruptcy case the IRS is prevented from recording a tax lien while the “automatic stay” is in effect. Since secured creditors have much more leverage than unsecured creditors in bankruptcy, preventing creditors from acquiring a “security interest” in what you own can be very important.

Power # 2: Keeping Collateral

If you want to keep the collateral or whatever property is secured through a lien, bankruptcy can help a number of ways, including:

  • If you are current in your payments on a secured debt and want to keep the collateral, you can usually do so. Your creditor will almost always be very pleased to allow you to keep the account in good standing. It may even be legally required to continue accepting your payments if you have fulfilled your end of the bargain.

  • If you have fallen behind on your payments on a secured debt, you will often be given a certain amount of time to bring the account current. Catching up on payments—such as on a vehicle loan—should be easier to do when you no longer have to pay other creditors

  • In some limited situations, the loan terms may be renegotiated (such as with a mortgage modification), potentially to waive catching up on late payments, lower the interest rate, and/or perhaps even lower the total to be paid.

  • Select kinds of secured debts—for example, judgment liens on your home—can be “avoided,” taken off your home title in a Chapter 7 case.

Power # 3: Dump the Collateral

If, without filing bankruptcy, you simply surrender collateral to a creditor because you can’t afford the payments, or simply do not need or want the collateral any, you can end up still owing much of the debt. That’s because after the creditor sells the surrendered collateral for less than the balance on the debt, and also adds in its repossession and other costs, you could easily end up owing much of the balance. And the next thing you know the creditor will sue you for payment of that balance.

And if the creditor somehow forgives the remaining balance, in some situations you can be hit with an income tax obligation. The amount forgiven may be considered “cancelation of debt income,” which is then treated as income upon which you have to pay income taxes.

Chapter 7 solves both of these problems. It would almost always discharge (permanently write off) any balance owing after the surrender of any collateral. And the discharge of a debt in bankruptcy is not treated as “cancelation of debt income,” so it is not treated as income and is not taxed. So you can freely surrender collateral in a Chapter 7 case if that is what you chose to do.