Modifying Secured Loans in Chapter 13
A secured loan is any loan where the lender has an interest in collateral they could potentially take to pay the debt, including mortgages, deeds of trust, liens, and car loans. For bankruptcy debtors with secured debt, they can choose to file chapter 7 or chapter 13. Chapter 13 may offer options to adjust the terms on which the secured loan is repaid. Chapter 7 debtors who keep secured property generally pay the secured loan on the same terms as before bankruptcy. In both chapters, turning the property over to the creditor is also an option. This post discusses how and in what circumstances chapter 13 can alter secured loans.
Chapter 13 bankruptcy's treatment of secured debt can be described as having a general rule combined with major exceptions that affect many cars and homes. Each proposed chapter 13 plan provides how each secured claim is to be handled. To obtain plan confirmation and proceed in chapter 13, the proposal for a secured claim must either be (i) accepted by the creditor, (ii) to pay the claim in a particular way, or (iii) to give up the property to the creditor. The general rule is that the plan must propose to pay the value of the property plus interest at a court-set rate from the date of confirmation. It might not be immediately apparent, but this treatment can be significantly more desirable to the debtor than their pre-bankruptcy loan terms.
This baseline treatment alters the creditor's payments in several ways. First, if the creditor is owed more money than the property is worth, the value of the property becomes a limit for the secured claim. The balance is treated as an unsecured claim (similar to a credit card), which in many plans will be paid partially or not at all. This can have the affect of reducing the principal paid on the loan. Second, the claim is paid at a court designated interest rate. This rate is often favorable, and lower than the rates of many secured personal property loans. Finally, the loan installment payment amount and durational term of the loan is set aside in favor of the bankruptcy plan. The loan is paid over the course of the 3 to 5 year plan, with the payment computed as necessary. Even without altering the amount owed or the interest rate, stretching out the payments can lower the debtor's monthly payment obligations.
Exception Concerning Primary Home
Several exceptions limit the availability of these bankruptcy powers to consumer debtors. For homes and residences, section 1322(b)(2) prevents chapter 13 plans from modifying claims "secured only by an interest in real property that is the debtor's principal residence." In short, if the collateral is the debtor's home, the debtor cannot use chapter 13 to force the creditor to modify the terms of the mortgage. It's worth noting that if the home isn't real property, such as some mobile homes, this limitation does not apply. Occasionally, the mortgage documents include provisions that cause the mortgage loan to lose its special treatment. However, in that case, or for a second home or rental property, there is still a practical limitation that the plan would have to propose to pay the entire value of the real property over the course of five years to get full benefit of a bankruptcy forced modification (i.e. a cramdown).
Exception for "recent" purchases
Known in the bankruptcy world as the "hanging paragraph" of section 1325(a), the bankruptcy code limits the ability of chapter 13 debtors reduce the balance on certain recent debts to the value of the collateral. For cars and other motor vehicles, the plan must pay the full amount of the claim if the purchase was made within 910 days (about 2 and half years) before the bankruptcy filing. For other personal property (e.g. furniture) the claim must be paid in full if the loan dates from the 1-year period prior to bankruptcy. Despite these limitations, chapter 13 debtors can still benefit from the court-imposed interest rate and the five year repayment window.
Qualification on Co-signed Debts
If the debtor is jointly obligated on a loan with another person who is not in bankruptcy, the third-party's obligation is not modified by a chapter 13 bankruptcy plan. As a practical matter, if the debtor's bankruptcy does not pay the claim in full at the contract rate of interest, the property is vulnerable to repossession post-bankruptcy (or during bankruptcy with court approval) based on the security interest granted by the non-debtor co-obligor. Due to this reality, some debtors will choose to pay the co-signed loan in full at the contract rate of interest during the bankruptcy so that no obligation remains for the co-obligor.