Should I Pay Debts Before Bankruptcy?

The goal for many debtors when filing a bankruptcy case is to obtain a discharge of their debts—often the more debt discharged, the better. Debts are discharged under both Chapter 7 and Chapter 13 bankruptcies. But these are different types of bankruptcy, depending on the two types of debt. Debt is divided into three types under the bankruptcy code:

1. Secured
2. Unsecured
3. Priority

Secured Debts

These are debts that are secured by property of the debtor—typically either a house or vehicle. The property that serves as security for the debt is often called collateral. When the debtor borrows money from a creditor in a secured transaction, there are two acts that occur:

• The debtor promises repayment of the money borrowed through a promissory note
• The debtor grants an interest in property through a security agreement

Those transactions are distinct from each other, which is important because a debt can be discharged in bankruptcy, but that discharge has no impact on the security interest granted to the creditor. For homeowners, a mortgage or deed of trust is the security instrument they have granted to the lender, in exchange for the funds loaned to the debtor. If a homeowner files for bankruptcy and seeks to discharge their home loan, a term in the mortgage allows the creditor to pursue foreclosure—a demand that requires the entire loan be paid or the property will be sold with proceeds covering the loan. Second mortgages and home equity loans are also secured debts, but are subject to different considerations than a primary mortgage. This works similar for car loans secured by a security agreement between the dealer and buyer—although often vehicle security agreements allow immediate repossession of the collateral upon default. Other types of secured debts include tax liens and judgment liens. A debtor can reaffirm their secured debts in bankruptcy—meaning the debtor agrees to continue paying the repayment plan and wishes to keep the collateral. Those debts will not be discharged in the bankruptcy and the assumption is that the debtor will be in a better position to pay those debts post-bankruptcy. If the debtor does not reaffirm a secured debt, that debt becomes unsecured and the collateral likely repossessed by the terms of the security agreement.

Unsecured Debts

Debts that are not secured by collateral are unsecured. A bankruptcy discharge will eliminate many of these obligations, including credit cards, medical bills, and personal loans. An unsecured debt can become a secured debt if the debtor allows the creditor to obtain a court judgment and record that judgment against the debtor’s real property. Some unsecured debts are distinguished under the law as “priority debts” and are subject to different requirements.

Priority Debts

Priority debts are unsecured debts subject to different rules under the bankruptcy code. These debts are not dischargeable in bankruptcy except in certain circumstances. Priority debts include:

• Income taxes
• Child support
• Spousal/alimony support
• Student loans

Who Gets Paid?

It depends on whether a trustee finds assets or income to distribute to creditors. In a “no-asset” Chapter 7 bankruptcy, no creditors get paid, although the debtor is still on the hook for their priority unsecured debts. In a Chapter 7 bankruptcy where a trustee does find non-exempt assets to liquidate, those assets will be distributed pro-rata among the priority creditors. If those assets do not satisfy all priority debts, remaining unsecured creditors receive nothing. However, if those assets do satisfy all the priority claims, the remaining assets will be distributed pro-rata among the remaining unsecured creditors. It is similar if a debtor will make payments under a Chapter 13 bankruptcy plan. Priority debts are paid pro-rata through the three to five years of plan payments. Once priority debts are satisfied, the remainder of the plan payments will be divided pro-rata among unsecured creditors. Determining which creditors to pay or not pay in the months leading up to a bankruptcy filing can be complicated and will involve a debtor making some difficult decisions. A debtor will put themselves in a better position to gain the fullest advantages from their bankruptcy by obtaining advice from an experienced Oregon bankruptcy attorney as early in the process as possible. A law firm or bankruptcy lawyer may offer legal advice on bankruptcy basics and bankruptcy law. For more information on this area of law, see our bankruptcy overview.