Can Secured Debt Be Discharged in Bankruptcy?

You probably know that most unsecured debt, such as credit card debt, can be discharged in bankruptcy. This means that you don’t owe these debts anymore and don’t have to pay them after the bankruptcy. But what about debts with collateral attached, like a car loan? 

These types of debt are called secured debts and most can be discharged in bankruptcy. But the bankruptcy discharge doesn’t mean you can keep the collateral debt-free. Because of the way secured debts attach to people and property, you must still pay for collateral if you want to keep it, even after a discharge. This article covers how secured debts work and explains how bankruptcy discharge affects secured debts in Chapter 7 and Chapter 13 bankruptcy.

Debts and Discharge

When you take out a loan to buy a car, the car becomes collateral for the loan. The contract you sign with the lender includes a security agreement. A security agreement gives the lender the right to repossess the car if you don’t make your payments. Debt that’s attached to collateral is called secured debt. 

Car loans aren’t the only kind of secured debt. Any debt you take on to finance a purchase is usually secured. A mortgage is a common type of secured debt. People also use secured debt to finance other purchases, such as furniture, boats, appliances, or lawn equipment. Most, but not all, secured debts are incurred to buy something. Sometimes people pledge something they already own as collateral for a loan. A title loan is an example of this.

Debt that isn’t attached to any collateral is called unsecured debt. A credit card is an example of unsecured debt. If you don’t pay your bill, the credit card company may sue you, but they can’t repossess the things you bought with the card. Some other examples of unsecured debts include medical bills, personal loans, student loans, and old utility bills.

When you complete a bankruptcy case, the bankruptcy court enters an order called a discharge. This order says you’re no longer responsible for paying certain debts. But your discharge order may not eliminate all of your debts. Some debts can’t be discharged in bankruptcy. Whether a debt can be discharged depends on the type of debt, the type of bankruptcy you file, and other factors.

What Debts Can’t Be Discharged in Bankruptcy?

Bankruptcy law specifies that certain types of debtscan’t be discharged in bankruptcy. Some of these nondischargeable debts include: 

• Debt resulting from misconduct: For example, if you hit someone while driving under the influence, any resulting debt — such as a criminal fine, restitution, or a personal injury lawsuit — isn’t dischargeable. 

• Domestic support obligations: Such as child support or alimony. 

• Certain types of tax debt and other debt owed to the government: The Bankruptcy Code has a complicated formula to determine whether income taxes are dischargeable, but recent tax debt usually isn’t. Many government fines and fees also can’t be discharged.

Some kinds of debt can’t be discharged in Chapter 7 bankruptcy, but can be discharged in Chapter 13 bankruptcy. Some examples include:

• Some divorce-related debt (not including child support or alimony)

• Debt resulting from intentional damage to property

• Debt incurred to pay a non-dischargeable tax debt

What Type of Debt Can Be Discharged in Bankruptcy?

Aside from these exceptions, most unsecured debt can be discharged in bankruptcy. Chapter 7 bankruptcy eliminates unsecured debts completely and quickly. A typical Chapter 7 case only takes about four to six months from start to finish. Chapter 13 bankruptcy, on the other hand,  involves a repayment plan that lasts from three to five years. Depending on your income and expenses, you may pay some or all of your unsecured debts through your Chapter 13 plan. When you complete your plan, any remaining unsecured debt is discharged. 

Secured debt can also be discharged in bankruptcy. But, as the next section explains, discharge is more complicated when it comes to secured debt.

Can Secured Debt Be Discharged in Bankruptcy?

Discharge affects secured debt differently depending on which type of bankruptcy you file. But the answer is still yes. Secured debts can be discharged in bankruptcy, even if you keep the collateral. To understand how that works, it helps to know some background about how secured debt works.

Secured Debt Has Two Types of Attachment

When you have a secured debt, the debt becomes legally connected to the collateral — in other words, it “attaches” to the collateral. This attachment is sometimes called a lien. For example, if you take out a loan to buy a car, the lender files a notice of lien with the state. The lien puts others on notice that you owe the lender money for this car. You can’t sell the car or transfer the title unless you pay the lender in full. When you pay the car, the lender releases the lien and the state sends you a clean title with no debts attached to it.

At the same time the debt is attached to your collateral, it is also attached to you. In legal speak, this means you have “personal liability” for the debt. The lender will likely send notice of the debt to the credit bureaus and the debt will appear on your credit report. 

Security Interests and Personal Liability Can Operate Independently

As mentioned, a secured debt is just one debt, but it attaches to both you (personal liability) and to the collateral (security interest). Here’s where it gets tricky. These two types of attachment aren’t attached to each other. From a legal standpoint, they can operate independently: If one is wiped out, the other one remains in place. 

• Example 1 – Deficiency Balance: A deficiency balance is a common example of how this works. Say Bob has a car loan. He gets behind on the payments. Bob’s lender repossesses the car and sells it at auction. The sale price is less than Bob owes on the loan. The lender sues Bob for the difference (sometimes called a deficiency balance). 

In this example, the car has been sold, so Bob’s debt is no longer attached to that car. But the debt is still attached to Bob. So Bob is still personally liable (responsible) for paying the remaining balance, even though he no longer has the car.

A bankruptcy discharge can do the opposite — the secured debt is no longer attached to you, but it’s still attached to the collateral. This doesn’t happen in every bankruptcy, and it works differently in Chapter 7 than in Chapter 13. The rest of this article discusses your options for handling secured debt in each type of bankruptcy and how discharge works in each scenario.

What Happens to Secured Debt in Chapter 7?

In Chapter 7 bankruptcy, the bankruptcy trustee can sell your belongings and use the money to pay your creditors. This is called liquidation. But there are exemption laws that protect some or all of your property from being liquidated. In most Chapter 7 cases, the trustee doesn’t liquidate anything because all the debtor’s assets are exempt. 

In other words, in Chapter 7, you can usually keep the car, furniture, or other collateral you’re using secured debt to finance. The debt attached to secured property means you have less equity in that property, so it’s more likely to be protected by exemptions. 

If the collateral is exempt, you can keep it. But you’ll still have to pay for it, even after the secured debt is discharged. Let’s go back to Bob and his car to examine how this works.

• Example 2 – Chapter 7 Discharge: Bob files Chapter 7 bankruptcy and gets a discharge. The discharge order wipes out Bob’s personal liability for his car loan, so the debt is no longer attached to Bob. But the debt is still attached to Bob’s car. The discharge order doesn’t wipe out the lender’s security interest.

In this example, Bob must keep paying his car loan if he wants to keep his car, even after his bankruptcy discharge. The loan debt is still attached to his car. If Bob doesn’t pay, the lender can still repossess the car. But once that car is no longer Bob’s car (because of the repossession), the debt is no longer Bob’s problem. It was only attached to the car. The lender can’t collect a deficiency balance from Bob because the discharge wiped out Bob’s personal liability for the debt.

To keep collateral in Chapter 7, you must usually be current on your payments. Your lender may also require you to sign a reaffirmation agreement.

Reaffirmation Agreements

A reaffirmation agreement is an agreement between you and your lender that both of you will still have the same rights and obligations after the bankruptcy as you had before. When you reaffirm a secured debt, that debt is excluded from your bankruptcy discharge. After your bankruptcy, the debt is still attached to both you and to the collateral. To be valid, a reaffirmation agreement must be approved by the bankruptcy judge.

Do you have to sign a reaffirmation agreement if you want to keep the collateral? It depends on your lender. 

In Example 2 above, Bob didn’t reaffirm his car loan. If he had, the loan debt would still be attached to both Bob and his car, even after the bankruptcy. Like Bob, many Chapter 7 debtors keep their cars after bankruptcy without reaffirming the debt. You might choose not to reaffirm a debt to avoid a potential deficiency balance in the future. Or you might not be able to reaffirm a debt because of your finances — the judge won’t approve a reaffirmation agreement if your paperwork shows you can’t afford the ongoing payments.

Some lenders require you to enter a reaffirmation agreement to keep the collateral. These lenders will repossess the collateral if you don’t reaffirm the debt, even if your payments are current. This is legal because the discharge eliminates your personal attachment to the debt. Wiping out this attachment also wipes out some of the rights and protections that were contained in your original contract with the lender. 

Most lenders, though, would rather have your payments than spend the time and money repossessing the collateral. These lenders typically allow you to keep the collateral and keep paying the loan after your bankruptcy, even without a reaffirmation agreement. 

Surrendering the Collateral

If you have secured debt, you’re not required to keep the collateral, even if it’s exempt. Bankruptcy gives you the option to surrender the collateral and walk away from the debt. Some reasons you might consider this option:

• You can’t afford the ongoing loan payments or you’re behind on the payments.

• The loan has a high interest rate.

• The collateral is damaged and you can’t afford to repair it.

• You owe more on the loan than the collateral is worth.

When you choose to surrender collateral through bankruptcy, your lender must accept this choice. When you legally give up your right to the collateral, the debt becomes unsecured. It’s treated like any other debt that isn’t secured by collateral. A Chapter 7 bankruptcy discharge usually wipes out your unsecured debts.

What Happens to Secured Debt in Chapter 13?

Chapter 13 bankruptcy gives you more options for dealing with secured debt than Chapter 7. You can surrender the collateral and walk away, just like in Chapter 7. If you want to keep the collateral, you’ll usually pay the debt through the Chapter 13 repayment plan. This plan lasts from three to five years. You make plan payments to the Chapter 13 trustee, and the trustee pays your creditors according to the plan terms. When you complete all the plan payments, the court enters a discharge order.

Through the Chapter 13 plan, the bankruptcy court has the power to adjust the loan’s payment term and reduce the interest rate. If the loan balance is more than the collateral is worth, the court can reduce the loan balance to match the value of the collateral. The part of the debt that exceeds the collateral’s value becomes unsecured debt. Secured creditors are ordered by the bankruptcy court to accept the terms of your Chapter 13 plan.

• Example 3 – Chapter 13 Plan: Bob is behind on his car loan. The loan balance is $18,000. The market value of Bob’s car is $10,000. Bob files Chapter 13 bankruptcy. The court reduces the loan balance to $10,000 to match the car’s value. The other $8,000 becomes unsecured debt. The court also reduces the interest rate. Through his Chapter 13 plan, Bob pays the $10,000 balance at the reduced interest rate over a three-year term. He also pays $800 of the unsecured portion. The other $7,200 of the unsecured portion is discharged at the end of Bob’s plan.

Also, unlike Chapter 7, in Chapter 13 you can keep the collateral even if you’re behind on the payments. For most secured debts, once the court has adjusted the debt as described above, you pay the adjusted balance in full through the Chapter 13 plan. Since you’re effectively refinancing the whole debt, it doesn’t matter that you were behind under the original contract terms.

The rules for real estate loans are different from loans secured by personal property. Most people can’t pay off their mortgage in full within a 3-5 year plan. If you’re behind on your mortgage and file Chapter 13, then each month you’ll pay your regular house payment plus a portion of the past-due amount. You make these payments through the Chapter 13 trustee. Also, unlike other secured debts, bankruptcy law doesn’t allow the court to reduce your mortgage balance to match the value of the property.

At the end of your plan, the Chapter 13 discharge eliminates any remaining unsecured debts that weren’t paid through the plan. This includes the unsecured portion of any secured debt. Since your secured debt was paid in full through the plan, there isn’t any remaining secured loan debt attached to either you or to the collateral. 

Let’s Summarize… 

Secured debts can be discharged in bankruptcy, but that doesn’t mean you get to keep the collateral for free. Most secured debt in Chapter 7 is discharged unless you reaffirm the debt. Even though the Chapter 7 discharge wipes out your personal liability for the debt, the debt is still attached to the collateral. You must pay the debt if you want to keep the collateral, even after bankruptcy. 

Most secured debt in Chapter 13 is paid through the Chapter 13 plan, so there’s no debt attached to you or your collateral when the discharge is entered. In both kinds of bankruptcy, you have the right to surrender the collateral. If you do, the debt is no longer secured.