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In bankruptcy, there are rules for how your creditors get paid. The rules are different in Chapter 7 and Chapter 13.
Chapter 7
The first thing that happens to property in a Chapter 7 bankruptcy is that the trustee collects all of the property that you are not allowed to keep. You are allowed to keep certain property during a Chapter 7 bankruptcy case, which is referred to as "exempt" property. Exempt property typically includes things you need to work and maintain a home. Learn more about and see examples of property exemptions. The property that the trustee collects is called nonexempt property, and is used to pay your debts.
Next, the trustee sells the property (usually at a public auction). The trustee uses the money that it receives from your property at the auction to pay your creditors. The trustee's job is to try to get as much money as possible to pay your creditors' claims.
How creditors are paid
Creditors are the people or companies you owe money to. There are three general kinds of creditors, and they are paid in the following order:
- Secured creditors,
- Priority unsecured creditors, and
- General unsecured creditors.
Whatever amount of money is left over after secured creditors and priority unsecured creditors have been paid is divided equally among all general unsecured creditors. They usually only get a small percentage of the amount they are owed, if they receive any distribution at all, in a Chapter 7 case.
Secured creditors
Secured creditors are creditors who have a security interest in your property. They have the right to get the property back if a debtor does not make payments.
A security interest is what guarantees that a debtor will repay the debt. For example, a mortgage on a house is a security interest. The bank is a secured creditor. If the debtor fails to make the mortgage payments, the mortgage allows the bank to take back the house to pay off the debt.
Some other examples include:
- A first or second mortgage on a house,
- Cars,
- Furniture,
- Major appliances, and
- Jewelry.
A trustee will only sell secured property if you owe less than what the property is worth. For example, you still owe $5,000 on your car but the trustee can sell your car for $12,000. Then the trustee will sell your car and pay the secured creditor $5,000 that has a lien on your car. Then they use the rest of the sale proceeds to pay other creditors. If you owe more than what the property is worth, then the trustee will likely give that property to the secured creditor.
Priority unsecured creditors
Priority unsecured creditors are parties that the bankruptcy law favors over other unsecured creditors, even though they do not have a security interest in the debtor's property.
Examples of priority unsecured claims include:
- Alimony or child support payments,
- The costs of the trustee in handling the bankruptcy, and
- Unpaid income taxes.
Note that priority unsecured claims are not discharged in a Chapter 7 bankruptcy.
General unsecured creditors
General unsecured creditors have neither a security interest in your property nor a priority over other creditors. Common examples include:
- Credit card debt,
- Medical bills,
- Utility bills, and
- Most store charge cards.
General unsecured creditors get paid last in a Chapter 7 bankruptcy, and usually only receive a small percentage of their claim.
Chapter 13
The trustee will not sell your nonexempt property in a Chapter 13 case. Instead, debtors pay an amount equal to the value of the nonexempt property to unsecured creditors. For example, a debtor with a nonexempt boat worth $7,000 and a timeshare worth $10,000 must pay unsecured creditors at least $17,000 over the course of their bankruptcy plan.
You have to file a repayment plan within 14 days of filing for bankruptcy (unless that time is extended by the court). The trustee must approve the repayment plan. The plan must provide for regular payments by you to the trustee, usually every two weeks or once a month. The trustee receives the payments and then pays the creditors according to what the plan says.
Learn more about Chapter 13 plans.
There are three kinds of claims that get paid under the repayment plan:
- Priority claims,
- Secured claims, and
- Unsecured claims.
Secured claims
Secured claims are claims that allow the creditor to take back the property if the debt is not paid. Common secured claims are cars and houses. If you want to keep property that is secured by a lien or mortgage you owe to a bank, the repayment plan might only require that the secured creditor receive at least the value of the property. This is true even if the amount you actually owe on the property is higher. (This is known as "cramming down" your loan.)
For example, let's say you still owe $15,000 on your car loan. Let's also say that the car is only worth $12,000 now. Under the repayment plan, the secured creditor must receive at least $12,000 for the debt to be considered paid off. This is helpful to you because the debt is considered paid off at $12,000 even though you owed $15,000. The bank holding the car loan would then have a $3,000 unsecured claim for the balance.
Note that cram down (paying the lower "fair market value" amount of a secured claim) is only available for cars purchased within the past 910 days (~2.5 years) prior to filing bankruptcy, or any other personal property purchased within 1 year of filing bankruptcy. You must pay the full amount of any mortgage on your principal place of residence, although you may be able to cram down investment property mortgages.
A secured creditor of property that you want to keep will also be paid during the course of a Chapter 13 plan the entire amount of any past-due balance at the time of filing bankruptcy. This is the total amount of monthly payments that were owed but not paid when you filed bankruptcy.
For example, you want to keep your home but have missed mortgage payments for 5 months prior to filing bankruptcy. Those five months of missed mortgage payments (along with any interest and fees) must be paid in full over the course of the plan, along with all the regular monthly mortgage payments that have come due during the plan.
Priority unsecured claims
Priority unsecured claims are given special status by the bankruptcy laws, even though they are not guaranteed with collateral like a home mortgage or car lien are. This means that the repayment plan must pay priority claims all of what they are owed before holders of unsecured claims can receive anything. Some examples of priority claims are:
- Income taxes,
- Costs of bankruptcy, and
- Child support and alimony.
Note that you cannot discharge priority claims in Chapter 7 or Chapter 13, and you must pay them in full through the Chapter 13 plan.
Unsecured claims
If a claim is not secured or given priority status by bankruptcy law, then it is unsecured. Creditors holding unsecured claims have no rights to take any property of the debtor if the debt is not paid. Some examples of unsecured claims include:
- Credit cards,
- Payday loans,
- Medical bills, and
- Utilities.
Many Chapter 13 debtors only pay a small portion of their unsecured debts through a repayment plan. Unsecured claims don't need to be paid in full, as long as:
- You pay creditors all disposable income during the bankruptcy, and
- Unsecured creditors receive at least as much as they would have received if you filed for Chapter 7 bankruptcy.
Disposable income is the amount of income left over after paying necessary living expenses.
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