Bankruptcy is about debts, and about how your different kinds of debts are handled under either Chapter 7 or Chapter 13.
Here’s the sentence that we’re exploring today:
Bankruptcy generally treats debts the same as long as they are in the same legal category, so understanding how Chapter 7 and Chapter 13 treat your debts begins with understanding the three main debt categories: secured, priority, and general unsecured.
Fairness to Creditors Means Equal Treatment
Bankruptcy makes a lot more sense if you know which of the three main categories of debts each of your debts fits into. Once you know this then you’ll be much more able to see how your two main bankruptcy options—Chapter 7 and Chapter 13—would handle your debts.
That’s because one to the main principles of bankruptcy law is that creditors who are legally the same are treated the same. And that’s because bankruptcy is not just about fairness between the debtor and his or her creditors but also fairness among the creditors. The most basic way to be fair among creditors is to treat them the same except when those creditors are legally different.
A good start in seeing how creditors are legally different is to determine whether a debt is a “general unsecured debt,” a “secured debt,” or a “priority debt.”
Chapter 7 “Straight Bankruptcy”
Just a brief introduction to this most common type of consumer bankruptcy—the point of filing a Chapter 7 case is to discharge—write off—your debts. It’s quick—usually taking barely 3 months from beginning to end.
You must qualify for Chapter 7 through the “means test”—a mostly income-based test, sometimes involving allowed expenses and other factors. Most people in a Chapter 7 case don’t pay anything on most of their debts, and have the opportunity to either pay for and keep, or else surrender, collateral and not pay their secured debts, such as their home mortgage and vehicle loan. Some debts aren’t discharged. Most people keep everything they own because usually it’s all “exempt”—protected. But otherwise the Chapter 7 trustee can take the asset, sell it, and distribute the proceeds to the creditors under a legal prioritization scheme.
Chapter 13 “Adjustment of Debts”
The point of Chapter 13, in contrast, is to pay a portion of your debts, especially special one that you want to or need to pay, and then discharge whatever you don’t pay. It’s not quick—usually taking 3 to 5 years from beginning to end. So it’s quite different from Chapter 7, but with same overall benefit of getting relief from your debts.
People file a Chapter 13 case usually because of the benefits it comes with. And some of the potential benefits are huge. It can help you save your home by giving your years to catch up on a mortgage arrearage, and maybe by “stripping” your second mortgage off your title, potentially saving you tens of thousands of dollars. Through Chapter 13 you can potentially “cram down” your vehicle loan, reducing your monthly payments and shave thousands of dollars off what you end up paying for your vehicle. Chapter 13 can stop your ex-spouse or support enforcement agency, the tax collectors, and student loan creditors in much more effective ways than Chapter 7 can. Especially if you have these types of debts, the Chapter 13 “adjustment of debts” can give you tremendous tools for solving our financial problems.
A secured debt is one which is secured by collateral or a lien on an asset. Your promise to pay the debt is backed up by a “security interest”–a right that you gave to the creditor over one of your assets—your real estate or some personal property—giving to the creditor the power to take that property from you if you don’t pay the debt. Besides voluntarily giving a creditor a right to the collateral at the beginning of the transaction, a debt that is not secured by anything can involuntarily turn into a secured debt, such as when a credit card creditor files a lawsuit against you and gets a judgment lien against your home.
Common secured debts are vehicle loans and home mortgages, and furniture and electronics store purchase contracts.
Secured debts are covered in the Bankruptcy Code primarily under Section 506. (See my next blog post for information about how secured debts are treated in a Chapter 7 bankruptcy, and various blog posts about how they are treated in Chapter 13.)
Congress has decided for policy reasons that some special categories of debts should be paid ahead of the rest of the debts—ahead of the general unsecured debts which we’ll discuss next.
So In the relatively low percentage of consumer Chapter 7 cases where the bankruptcy trustee receives some of your assets for distribution to your creditors, the priority debts are paid ahead of your general unsecured creditors. Congress has also determined the order, or the “priority,” in which these special debts are to be paid so that the ones higher on the list get paid in full before the other priority debts are paid anything, much less debts that aren’t priority debts at all.
In a Chapter 13 case, you have to pay all your priority debts in full before your case is completed. That’s often not a bad thing because these debts often can’t be discharged and so you’d want to pay them off while under the protection of the Chapter 13 payment plan.
The list of priority debts is laid out at Section 507 of the Bankruptcy Code, but this list includes many kinds of debts which do not apply to consumers and small businesses. The most common types of consumer priority debts are the following, in descending order of priority:
child and spousal support
the administrative costs of the bankruptcy case
certain income taxes
some other kinds of taxes
General Unsecured Debts
An unsecured debt is simply one not secured by collateral or through a lien in something you own. A general unsecured debt consists of nothing but a written (usually) promise or obligation to pay the debt. An unsecured creditor has no right to anything that you own without first getting a judgment against you, and even then its lien is behind the secured creditors.
General unsecured debts are simply unsecured debts which don’t fit within any of the priority debts discussed immediately above. These are the “leftover” class of debts—if the debt is not presently secured (even if it might have once been) and doesn’t fit within the narrow set of “priority” debts, it’s a general unsecured debt.
Examples of general unsecured debts are most credit cards, medical bills, deficiency balances on repossessed vehicles or other collateral, many personal loans, and numerous other kinds of debts.
In a Chapter 7 case most general unsecured debts are discharged—permanently written off. Every creditor can challenge the discharge of its debt, but only on very narrow, mostly fraud-based grounds so this usually doesn’t happen. If a Chapter 7 trustee collects a non-exempt (unprotected) asset from you, the general unsecured debts might possibly be paid a portion of the proceeds, but often the money all goes to the priority debts, plus the trustee’s fee and other costs.
In a Chapter 13 case the general unsecured debts are usually paid something through your payment plan, but often only pennies on the dollar and sometimes nothing at all. How much they are paid depends on many factors, but mostly on how much you can afford to pay during the 3-to-5-year payment period and what other secured and priority debts are ahead of them. At the end of the Chapter 13 case most or all the remaining general unsecured debts are discharged.