Secured Debts in Chapter 7 Bankruptcy: An Overview

Most people have a loan secured by property, such as a mortgage or a car loan. These debts, called "secured debts," can be tricky in Chapter 7 bankruptcy. Although you can wipe out or "discharge" a secured loan in Chapter 7 bankruptcy, you'll lose the property you purchased if you don't pay for it after bankruptcy. Here's why.

When taking out a secured loan, you agree the purchased property will be collateral, creating a voluntary "lien." The lien lets the creditor recover the property if you don't pay—even if you file for Chapter 7 bankruptcy. Filers don't always lose secured property in Chapter 7, but keeping it will depend on the following:

• whether your payment is current and you can protect the property's equity using a bankruptcy exemption, or
• if you can redeem the property and pay off the reduced balance (this option isn't always available).

We explain both Chapter 7 secured property approaches below and briefly cover options available in Chapter 13. However, keep in mind this article addresses voluntary liens only. You can learn about voluntary and involuntary liens in What Happens to Liens in Chapter 7 Bankruptcy?

What Is a Secured Debt?

If you're making payments on an expensive property—such as a home, car, diamond ring, computer, or couch—you've likely agreed that the property will serve as collateral and the lender can sell the collateral if you don't pay as promised. For instance, the lender might repossess a car or foreclose on a home if you fall behind on the payment.

Whether the lender must go to court before selling the property will depend on your state's laws. Also, some states will give the lender a "deficiency" judgment for the remaining balance if the sale brings less than the amount owed.

How Secured Debt Works in Chapter 7 Bankruptcy

You can eliminate your responsibility to pay a mortgage, car payment, or another secured debt in Chapter 7 bankruptcy. However, filing for bankruptcy doesn't take away a lender's lien rights to reclaim the property. Why? Because a secured debt has two parts:

• Your responsibility to pay. You have an obligation to pay a secured debt just like any other debt. Chapter 7 bankruptcy wipes out this personal liability if it's the type of debt you can discharge in bankruptcy.
• The lender's "lien" right to recover property. The second part of a secured debt is the creditor's legal claim—known as a "lien" or "security interest"—on the property serving as collateral. The lien gives the creditor the right to repossess the property or force its sale if you don't pay the debt. Because the bankruptcy discharge doesn't affect liens, the lender can use the lien to take back the property if you remain behind on payments.

In some situations, you can ask the bankruptcy court to remove the lien as part of your bankruptcy case. For instance, the bankruptcy court might remove an involuntary property lien placed by a state court after trial if the lien interferes with a bankruptcy exemption.

Secured Debt Options in Chapter 7 Bankruptcy

If you have a debt secured by property and you file for Chapter 7 bankruptcy, here are your options, assuming you meet all requirements:

• Let the property go back to the bank. You can walk away free and clear by surrendering the property and discharging the underlying debt. This option is available to all filers.
• Keep the property and continue making payments. You can continue under the same contract terms as long as you're current on your payments and can protect your equity with a bankruptcy exemption. This process is known as reaffirming the debt.
• "Redeem" the property by paying its fair market value. You can keep some types of property by "redeeming" it or paying what it's worth in one lump sum payment. However, other requirements must be met. For instance, you can't redeem business property or real estate. Learn more in Redeeming Secured Property in Chapter 7 Bankruptcy.

Find out more about keeping secured property in Chapter 7, including how to keep your house or protect a car.

How to Keep Secured Debt in Chapter 7 Bankruptcy

If you're wondering what it means to protect equity with a bankruptcy exemption or want more details about redeeming property in Chapter 7, keep reading.

Why You Must Bring Payments Current Before Filing

If you're behind on a secured debt payment, like a mortgage or car payment, filing for Chapter 7 bankruptcy won't help you keep the property. Why? Because Chapter 7 doesn't have a mechanism to catch up on payment arrearages.

If you can't make arrangements to bring your payments current, you'll likely lose the property after your case ends. You could lose your asset even sooner if the court lifts the automatic stay to allow for foreclosure or repossession.

Because there's no way to force a lender to work with you in Chapter 7, if you want to keep secured property, ensure you're current on payments and can protect all property equity before filing.

Why You Must Protect Equity With a Bankruptcy Exemption

You can protect some property when you file for bankruptcy, but the amount you can keep will depend on your state's bankruptcy exemptions. If you owe more on a secured loan than the property securing the debt is worth, you don't have equity and can skip this step. However, suppose you can't protect all of a property's equity. In that case, the Chapter 7 bankruptcy trustee assigned to the case would sell it for your creditors' benefit.

Here's how it works.

Example. You owe $3,000 on a car worth $6,000, leaving you with $3,000 in equity. Your state's vehicle exemption will let you protect $1,000. In this case, the trustee would sell the car and pay your secured creditor the $3,000 you owe. You'd receive the $1,000 exemption amount. The remaining $2,000 would go to unsecured creditors, minus any costs of sale and the trustee's commission.

Would Chapter 13 Help If I'm Behind on a Secured Debt Payment?

Yes. If you're behind and want to keep the property, Chapter 13 bankruptcy is probably the better choice. In Chapter 13, you can make up missed payments over time using the Chapter 13 repayment plan. However, keep in mind that you'll need to be able to afford the regular monthly payment and meet other Chapter 13 payment plan requirements, too.

What Does Redeeming in Chapter 7 Bankruptcy Mean?

When you redeem property in Chapter 7 bankruptcy, you can satisfy the loan by paying the value of the property in one lump sum payment. If you and the creditor disagree about how much the property's worth, the court will decide at a "valuation" hearing. The judge will extinguish your obligation to the creditor after you pay the agreed-upon lump sum amount.

If you're wondering how bankruptcy exemptions come into play here, the simple answer is they don't. Filers redeem property in Chapter 7 bankruptcy only when property equity doesn't exist because one of the requirements is that you owe more than the property is worth.

Restrictions on Bankruptcy Redemption

You can redeem property in Chapter 7 bankruptcy only if you meet all of the following conditions:

• The debt is a consumer debt on goods used for personal or household purposes. You can't use the redemption process to redeem property that secures business debts, such as a car you use for business purposes.
• The property is personal property. Personal property is all property other than real estate. You won't be able to redeem your residential home or vacation house.
• The property is tangible. You must be able to touch the property. Intangible property includes things like investments, stocks and bonds, and intellectual property rights.
• The property isn't of value in the bankruptcy case. The property can't have equity that could be used in the bankruptcy case (you wouldn't benefit from redemption if the property had equity).

Should You Redeem Property in Chapter 7 Bankruptcy?

A Chapter 7 property redemption is often a good option if your debt balance exceeds the property's value. Why? Because if you redeem the property in bankruptcy, the creditor must accept the item's value as payment in full, even if you owe significantly more.

The main drawback to redemption is most debtors can't afford to pay the property's value in a single payment. Some companies specialize in lending to people seeking to redeem property, so a loan might be an option. Or you might be able to get the money from a friend or relative.

How to Redeem (Pay Less on) Secured Property in Chapter 13 Bankruptcy Through a Cramdown or Lien Stripping

Chapter 13 offers ways to reduce the amount owed on secured property, but bankruptcy practitioners refer to these procedures by different names. You'll use a "cramdown" to reduce what you owe on personal property, like your car. You can even use a Chapter 13 cramdown on investment real estate.

A "lien strip" is used to pay significantly less on a wholly unsecured mortgage on your residence. You'll find more information about reducing your residential home mortgage in Chapter 13 in Keep Your House in Chapter 13 Bankruptcy.

Need More Bankruptcy Help?

Did you know Nolo has been making the law easy for over fifty years? It's true—and we want to ensure you find what you need. Below you'll find more articles explaining how bankruptcy works. And don't forget that our bankruptcy homepage is the best place to start if you have other questions!

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.