Secured Debts in Chapter 7 Bankruptcy

Secured creditors are those that receive an interest in the debtor’s property in connection with extending credit or providing services. The secured creditor’s interest in a debtor’s property is called collateral and may be recovered against by the secured creditor if a debtor fails to repay a loan or pay for services rendered. A security interest is generally recorded as a lien against the collateral.

Through Chapter 7, a debtor’s assets are liquidated to pay off debts owed to creditors. Amongst a debtor’s creditors there are different rights and priorities that affect the ownership of a debtor’s assets and the priority in which creditors get paid. This article is intended to summarize the treatment of secured debt in Chapter 7, however this is a very complex legal topic that depends on the facts of each individual case. Accordingly, if you require further information regarding how secured debt will be treated in your circumstances, you should contact a bankruptcy attorney.

Types of Secured Debts

Among the various types of secured debt, mortgages secured by a borrower’s home, loans secured by cars or other valuable assets, or business loans secured by the assets and revenue of a company are the most common. Sometimes a single property can be used as security for more than one debt, such as a second mortgage on a home. 

Another type of secured debt arises from a debtor’s failure to pay an unsecured claim, which entitles creditors to file a lien against the debtor’s property. Liens appear in circumstances such as failure to pay property taxes, failure to pay for services rendered on real property or equipment, or debts from a judgment.

Treatment When Debtor Elects to Keep Property

In certain limited circumstances, a debtor can retain property that is subject to a lien or security interest. If the debtor has the ability to pay and can garner a secured lender’s consent, the debtor may reaffirm the debt. Reaffirmation takes the property and the debt owed out of the debtor’s Chapter 7 estate and creates an obligation for the debtor to continue making regular payments to the lender.

A Chapter 7 debtor may also redeem the property by paying the secured lender the total amount of its secured claim, less the debtor’s exemptions. For example, if a debtor owes $15,000 as a car loan and has claimed a $7,500 exemption on the car, the debtor can exercise its redemption right to retain the car by paying the lender $7,500. The funds for this redemption must come from the debtor’s equity or non-estate sources, such as a loan from a third party.

Treatment When Collateral Is Sold

Unless a debtor elects to retain property or a creditor receives relief from the automatic stay to recover or sell the property, the Chapter 7 trustee will auction the collateral for sale. A secured creditor is generally entitled to payment from the sale of the collateral, less the cost of sale, up to the amount of its claim. However, in certain circumstances (e.g., preferential transfer, failure to perfect) the Chapter 7 trustee may seek to avoid the secured creditor’s lien so that the proceeds of the sale will become property of the estate and the secured creditor would be treated as a general unsecured creditor.