What is the Difference Between Secured and Unsecured Debt?

Bankruptcy, for all its negative connotations and scary images its conjures, is a useful tool for many individuals who simply need a fresh start when it comes to their finances. Filing for bankruptcy does have some substantive effects on your credit score, but it’s the right choice for many people. 

When you file for bankruptcy, you must take an inventory of your debts and classify them as either secured or unsecured debts, or creditor claims. The distinction between these types of debts is that secured debts have some sort of collateral to guarantee the debt. Perhaps the most common example of secured debt is a mortgage loan; the lending institution will have a lien on the property so that it can foreclose on it and sell it if the current debtor cannot make the mortgage payments. Lenders for car loans also have a tangible asset they can repossess and sell if the debtor doesn’t make payments–the car itself. 

Creditors with unsecured debts, on the other hand, do not have the benefit of a tangible asset to use as collateral. Examples of unsecured debt include credit card debt and medical debt. To illustrate, let’s take the example of medical debt. If someone is involved in a serious car accident and has to spend weeks in the hospital, out-of-pocket costs could reach into the tens of thousands (or hundreds of thousands, depending on whether or not the victim has insurance). When it becomes clear that the victim cannot pay the medical debt, the healthcare provider or hospital cannot repossess the stitches on the victim’s arm or the percocet already taken by the victim to ease the pain. 

So, what can the creditor do? It can transfer the debt to a collection agency or take the debtor to court. However, if the debtor files for bankruptcy, the unsecured debt that is eligible for discharge (forgiveness) will be wiped away and the creditor will likely get nothing. An important note here is that some unsecured debt, like child support, alimony, and student loans are not eligible for discharge; these are considered to be priority unsecured debts. 

Chapter 7 vs. Chapter 13

Remember, your choices if you are filing for bankruptcy on your own behalf (and not for a business) are Chapter 7 and Chapter 13. In a nutshell, Chapter 7 involves your eligible unsecured debt to be discharged. Conversely, Chapter 13 involves a repayment plan to your creditors that lasts 3-5 years. 

Secured debt is treated much differently in a Chapter 7 bankruptcy relative to a Chapter 13 bankruptcy. You are released from the personal responsibility to pay your secured debts in a Chapter 7 filing; however, if you choose this option, your creditor is able to seize your collateral assets to satisfy your secured debts. If there is money left over after your creditors sell your collateral assets, the priority unsecured creditors we discussed earlier will receive the leftover funds. Furthermore, any nonexempt assets you have that are not collateral may be sold to help pay down your debts. 

In a Chapter 13 filing, you will generally set up a repayment plan with your secured and unsecured creditors. Your Chapter 13 repayment plan must pay back your priority unsecured debts in full. When it comes to nonpriority unsecured debts and your secured debts, you will be able to work out an arrangement that lets your creditors recoup at least some of the money you owe. For these reasons, Chapter 13 is much better for debtors who do not want to part with any assets or property. 

Conclusion

This blog is only intended to serve as an introduction to how secured and unsecured debts are handled in a personal bankruptcy. You will need to consult with an experienced attorney to both figure out if filing for bankruptcy is the best option and ensure your bankruptcy meets your goals. Our firm would like to help you realize a better financial tomorrow. Get in touch with us to discuss your options.