FAQ #15: What is the difference between secured and unsecured debt?

Secured debts are those debts in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan. In the event that the borrower defaults, the creditor takes possession of the asset used as collateral and may sell it to regain some or all of the amount originally lent to the borrower. An example of this is repossession of a car or foreclosure of a home. If the sale of the collateral does not raise enough money to pay off the debt, the creditor can often obtain a deficiency judgment against the borrower for the remaining amount.

Unsecured debt refers to any type of debt or general obligation that is not collateralized by a lien on specific assets of the borrower. In other words, in the event that the borrower fails to pay the debt, there is no collateral that the lender may recover to mitigate its financial losses resulting from the debtor’s failure to pay without suing in court.

What’s my car worth? Automotive Valuation for Bankruptcy Purposes

The Bankruptcy Court has provided some guidance for valuing a car for the purpose of a Bankruptcy Petition:

“[A]djusting the Kelley Blue Book or N.A.D.A. Guide retail value for a like vehicle by a reasonable amount in light of any additional evidence presented regarding the condition of the vehicle and any other relevant factors” is an appropriate means of reaching retail value. In re Morales, 387 B.R. at 45.

The court agrees that the Kelley Blue Book is an appropriate starting point for a valuation analysis. The values it supplies are based on actual transactions occurring in relevant regional markets. They are admissible under Federal Rule of Evidence 803(17). The Kelley Blue Book is objective, serves the interests of standardization and predictability, and is cost-effective, which benefits the parties.

But the Kelley Blue Book retail values cannot be the final word. Retail value under 11 U.S.C. § 506(a)(2) and the Kelley Blue Book’s suggested retail value have slightly different meanings. Suggested retail value under the Kelley Blue Book “assumes that the vehicle has been fully reconditioned,” and only “represents dealers’ asking prices and... the starting point for negotiation” between a consumer and a dealer. Kelley Blue Book Auto Market Report 4 (May 2010)

By contrast, 11 U.S.C. § 506(a)(2) requires the retail value to mean “the price a retail merchant would charge for property of that kind considering the age and condition of the property.”

The Kelley Blue Book value therefore must be adjusted for two things. First, it must reflect the actual condition of the car if that condition is not optimal. Second, it must reflect the fact that the Kelley Blue Book value is the asking price for a retail sale, not the final price, as it is reasonable to believe that dealers do not sell vehicles frequently at the asking price."
(See In re Penny)

As a practice tip, consult both NADA and Kelley Blue Book private party value as a starting point, and then consider the actual condition to make appropriate adjustments.

Is my mortgage secured or unsecured debt? How does this effect Chapter 13 debt limits?

A mortgage is a legal instrument typically securing a debt against real property, such as your residence. It would seem obvious, therefore, that a mortgage is a secured debt. But this is not always true.

In our current real estate market, many homes are underwater. Not in the literal sense (although this is also true for many homeowners in Massachusetts after the storm this past week). Figuratively, when a home is described as "underwater" it refers to the mortgages on said home having a value greater than the current fair market value of the home.

When filing a Chapter 13 bankruptcy, a wholly unsecured second mortgage or even the unsecured portion of an undersecured first mortgage should be listed as unsecured debt. Depending on other circumstances you may or not be able to to discharge this "unsecured" debt, however that doesn't change the fact that the Court will consider it unsecured.

Why does this matter?

When filing a Chapter 13 bankruptcy, there are debt limits defined by 11 U.S.C. §§ 109(e). Said debt limits were recently raised, effective April 1, 2010. Under the current limits, a Chapter 13 bankruptcy will be dismissed if the debtor has unsecured debt greater than $336,900 and/or secured debt greater than $1,010,650. As of April 1, 2010, those figures rise to $360,475 and $1,081,400 respectively.

Consider the following scenario:
A debtor owns a $600,000 home but has $900,000 in mortgages. The debtor has a car with a lien of $20,000 (secured debt) and credit card (unsecured debt) of $100,000.

If the entire mortgage debt was considered secured then the debtor would be under the debt limits with a total secured debt of $920,000 and a total unsecured debt of $100,000. Unfortunately, because the Court considers the $300,000 of "underwater" mortgages unsecured, the debtor has a total unsecured debt of $400,000, which is above the debt limits. This debtor would, therefore, be ineligible to file for relief under Chapter 13 and be forced to seek other relief (possibly filing for bankruptcy under Chapter 11).

This is the exact scenario articulated by a California Court in an unpublished decision: In re Estrada.

Estrada refers to a Ninth Circuit decision: In re Scovis, 249 F.3d 975, 982 (9 th Cir. 2001). In Scovis, the Court stated that a "vast majority of courts, and all circuit courts that have considered the issue, have held that the unsecured portion of undersecured debt is counted as unsecured for 13 § 109(e) eligibility purposes."

It appears that this is also the law in Massachusetts. In re Marrama, 345 B.R. 458, 472 n.23 (Bkrtcy.D.Mass. 2006) In Marrama the court referenced Scovis and noted that the debtors failed to list the unseured portion of an undersecured mortgage as unsecured debt, which would have resulted in a greater unsecured debt.

This also indicates the importance of completing your bankruptcy schedules correctly. To consult with an attorney regarding filing for bankruptcy, click here.