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Secured Debts, the Focus of Many Bankruptcies

Debts secured by liens on your property or possessions often grab the most attention during a bankruptcy case.

 

“General unsecured” debts, discussed in my last two blog posts, are handled in a relatively straightforward fashion in bankruptcy. In a Chapter 7 case, they are generally discharged (legally written off) without any opposition by the creditors. Those creditors usually get nothing. And in a Chapter 13 case, “general unsecured” debts often are paid simply whatever money is left over, if any, after the secured and priority debts and the trustee and attorney fees are paid. There’s because the creditors usually don’t have much to fight about.

But with secured debts—debts secured by collateral or through some type of lien—your property or possessions that are providing security are often a point of contention.

The next few blog posts will be about how to use Chapter 7 or Chapter 13 to deal with the main kinds of secured debts. Today I start with some important points that apply to most secured debts.

Two Agreements in One

A secured debt effectively involves two interrelated agreements between you and the creditor. First, the creditor agreed to give you money or credit in return for your promise to repay it on certain terms. Second, you gave the creditor certain rights to the collateral, including the ability to take that collateral from you if you don’t comply with the terms of your promise to repay the money.

Generally, bankruptcy will only undo that first agreement—your promise to pay. In contrast, your creditors’ rights to collateral generally survive bankruptcy.

The Value of Collateral

How much the collateral is worth as compared to the amount of the debt becomes very important as to what happens to that collateral.

If the collateral is worth a lot more than the amount of the debt, this debt is considered well-secured. Then there’s a much better chance that the debt would be paid in full.  You’ll really want to pay off the relatively small debt to get the relatively expensive collateral free and clear of that debt. Or if you didn’t make the payments the creditor will get the collateral and sell it for at least as much as the debt.

If the collateral is worth less than the amount of the debt, the debt is considered undersecured. It’s less likely that such a debt would be paid in full because in return you’d get collateral worth less than what you’re paying.

Depreciation of Collateral, and Interest

Since the value of the collateral is such an important consideration for a secured creditor to be made whole, the loss of its value through depreciation is something that creditors care about, and about which the bankruptcy court respects.

Also, in most situations secured creditors are entitled to interest. So, you’ll see in our next blog posts that when there are conflicts with secured creditors—on home mortgages or vehicle loans, for example—issues about depreciation and interest become important.

Insurance

Virtually every agreement with a secured creditor—definitely those involving vehicles and homes—requires that you carry insurance on the collateral. If the collateral is damaged or destroyed, this insurance usually pays the debt on the collateral before it pays you anything. And, if you don’t get the required insurance, the creditor itself can buy insurance to protect only its interest in the collateral AND charge you for it.

 

With these points in mind, the next blog post will tell you your options with your vehicle loan under Chapter 7.

 

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Short Sales of Your Home–Sometimes Necessary, Often End Not As You Expected

A short sale might be your best alternative. But they can be hard sales to close, and may not accomplish what you hope.

 

Someone Doesn’t Get Paid

In a short sale, you sell your house by “shorting”—underpaying—one or more of the lienholders, because the sale price is not enough to pay everyone in full.

In the depths of the recent real estate crash, a large percentage of home sales were short sales because the value of so many houses had fallen below what was owed on them. Even though property values have climbed in many parts of the country, there are still millions of homes “under water,” and so can only be sold in a short sale.

Why Short Sales Are Harder to Close

You can imagine that if a mortgage holder or someone else has a lien on your home and a legal right to be paid in full, it will be reluctant to take anything less than payment in full before releasing its lien. And these lienholders can include not just voluntary ones like your first and maybe second mortgage, but also judgments, income taxes, support obligations, unpaid utilities, and property taxes. Generally all lienholders must consent and release their liens, or the sale cannot occur.

Their Benefits

Beyond getting out of a house that you can’t afford, the main benefit of a successful short sale is that it avoids a foreclosure on your credit record. Although in general that is a sensible goal, a short sale is also likely detrimental on your credit record—after all you are not paying one or more of your creditors in full. Also, given how many millions of foreclosures occurred in the last 5-6 years, there is some indication that there is and will continue to be less credit record difference between a short sale and a foreclosure. Depending on the rest of your credit record, now and in the future, focusing on avoiding foreclosure may not be as important as you may think.=

Short Sales Often Do Not Come Together

Most short sales take much more effort and time to pull off than expected, so they usually take longer, and then often fail to close, putting the homeowners further behind and no better off. The reasons they often don’t work are:

  • Unhelpful and slow mortgage lenders: In a short sale usually the first mortgage holder has to give some money from the sale proceeds to a junior lienholder or two. The only reason the first mortgage holder would do that is if getting a little less out of the sale is better than going through the delay and cost of a foreclosure. Although many mortgage lenders have gotten better organized and staffed to process short sales, working with them can still be like pulling teeth.
  • Any lienholders can refuse to cooperate and kill the deal: When the pie that is too small, it’s hard to make everybody happy and cooperative. Any lienholder can refuse to take the proposed reduction in payment and jeopardize the closing.
  • The realtors and other middlemen often have the most to gain: Realtors and others in the real estate sales industry often benefit more from a short sale than you do. There are good reasons that unbiased observers—like bankruptcy judges—tend to discourage short sales.

Short Sales Can Be Dangerous

You could end up legally liable to those lienholders who were not paid in full, and could also potentially owe extra income taxes.

  • Unpaid balances on the junior mortgages and liens: You may be told that you will not be liable on debts that aren’t paid in full from the home sale, but that’s not always true. You need to be sure that the settlement documents and the applicable law in fact cut off any liability. Be careful about feeling forced to accept some remaining liability just to get the deal done.  
  • Potential tax consequences: This issue is a complicated one that can’t be covered here in adequate detail. The main point is that debt forgiveness can be treated as income subject to taxation unless you fit within one of the exceptions. Make sure you talk with an appropriate tax specialist about this before investing any time or expectations in the short sale option.  

Short sale attempts often fit two wise rules of thumb: 1) desperate actions often lead to no good, and 2) if it sounds too good to be true, it probably is.

 

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