Secured vs. Unsecured Debt

The distinction between secured and unsecured creditors is important to determine the rights of creditors when a bankruptcy case is filed.     While both secured and unsecured debts are typically dischargeable, secured creditors have enhanced rights to payment by the Debtor unless the Debtor is willing to allow the return of the collateral for their debt to the creditor.

Secured creditors are those who a have a lien on property owned by the debtor, which is called the collateral for the debt.    The collateral helps secure the creditors right to be paid because they have not only the borrowers promise to pay but also the right to recover their collateral and apply the proceeds to the debt.    Common secured creditors include mortgages on homes or other real estate and car loans.    There are also agreements that include agreements to allow a creditor a lien such as purchase money security interests for furniture and other consumer goods purchased on account .    Debtors may not be aware of this type of security interest.    For businesses, creditors can secure their debts with a wide variety of collateral from equipment to money owed to the debtor.

When a creditor has a security interest, the debtor must make arrangements to pay the creditor’s secured claim in order to be assured the right to retain collateral (unless the creditor agrees otherwise).     In a Chapter 7 case, unless there is an equity in a property, the debtor may typically keep the collateral for secured debts if the payment is current and the debtor agrees to continue making the payments.    Some creditors will also require that the debtor sign a reaffirmation agreement that also revives the debtors promise to pay.   The distinction is that, without a properly signed and filed reaffirmation agreement, the creditor would be unable to recover any money from the debtor after selling its collateral, even if the proceeds were inadequate to repay the creditor in full.  Depending on the bankruptcy chapter, there are a number of ways for a debtor to adjust the rights of secured creditors based upon the value of their collateral for the debt.     Where the collateral is worth less than the amount owed on a debt, the creditor may have the right to an unsecured claim in addition to its secured claim.    This would allow the creditor to receive a portion of the money provided for unsecured creditors in addition their collateral or payments made to retain the collateral.

Unsecured creditors are creditors who do not have collateral for their debt.   Their right to recover is based solely on the debtors promise to repay the debt.    In a bankruptcy case, these are the creditors who receive the monies collected by the Chapter 7 trustee, reduced by the expenses of the trustee or receive the monies allocated in other chapters.   General unsecured creditors are paid on a pro rata basis.   This means that each creditor should receive the same number of pennies for each of the dollars that it is owed as all of the other unsecured creditors.    The exception to this rule is unsecured creditors who might also be priority creditors.   Priority creditors are placed at the front of the line and get paid before the other unsecured creditors.     Priority creditors are given priority status for policy reasons.  Common priority creditors include child support and alimony as well as selected tax claims.    Often, but not always, the same claims that have priority status are also non-dischargeable in bankruptcy.  (Student loans are not dischargeable and not priority claims.)     Most credit cards, medical bills and signature loans are unsecured.   Deficiency balances, resulting when the proceeds from the sale of collateral are not adequate to pay a secured debt in full, are unsecured.

In some instances and under some chapters, debtors can benefit from having the Court determine that a creditor’s claim is partially or fully unsecured.   This may allow a debtor to modify the agreement with a secured creditor in bankruptcy or even treat then as a general unsecured creditor.