Kentucky Bankruptcy Law

Counsel with Care

Cross-collateralized Loans in Bankruptcy

I have talked in here before about the risks involved in doing all your banking with one institution. What I am cautioning against is having your bank accounts with the same institution where you have a car loan, home loan, and signature loan or any combination thereof. To explain one of the reasons to avoid this, I will describe a common scenario: Debtor buys a car using their bank or credit union because of the rates or because of the ease of doing business in the same place. Later, Debtor needs a little extra cash and so they take out a signature line of credit. The bank is eager to offer this line of credit and even gives Debtor a lower interest rate so long as they cross-collateralize the loan against the car. Of course, it is no longer really a signature loan, but a secured loan but we will call it “signature” for convenience.

Debtor ends up having to file bankruptcy and they want to keep their car. Let us say the car is worth $5,000.00 and the purchase loan balance is $7,000.00 with the signature line of credit being another $3,000.00. Debtor qualifies for a Chapter 7 and their budget shows they can afford the payments to reaffirm on the $7k loan, but it is too tight to be able to also reaffirm on the $3k loan. Here is the problem: the bankruptcy court will be reticent to approve a reaffirmation where you are promising to pay back two loans instead of just the purchase money loan AND where your budget does not support it. Your lawyer would be a bit foolish to sign off on such a reaffirmation, but their signature promises that they have reviewed it and that reaffirming both loans would not create a hardship, when clearly it would be a hardship. So, it the reaffirmation has to go to the judge for approval.

The bank is holding all the cards here because that second loan, even though it is a non-possessory, non-purchase money security interest under 11 USC 522(f)(1)(B), is not one that can be stripped off in a Chapter 7 because it is secured against a car rather than household goods or the like. So, to go into a Chapter 7, the Debtor has to decide what is most important and what they can let go of. The Debtor has to play a financial game of chicken and say to the credit union to either let them just pay the purchase money loan alone and keep the car or come on and pick the car up (not literally, there are motions to be filed). Some banks will cut their losses and at least get paid for the purchase money part, but others refuse to make deals believing it makes them look weak.

There is one other option: Chapter 13. If the car was purchased more than 910 days prior to filing bankruptcy and the second loan was incurred more than a year before filing, then great things happen. Under provision 11 USC 506 and 11 USC 1325(a)(hanging paragraph), then the purchase money debt of $7k gets crammed down to the $5k value of the car and the $3k non-purchase loan gets stripped off as an unsecured debt.

To figure out what the best approach is going to be in this circumstance, your attorney will need to look at a lot of different factors and advise you as to the best course of action.

May 24, 2012 - Posted by | Bankruptcy, Chapter 13, Chapter 7, Plan, Plan payments, reaffirm or surrender), Security interests | , , , , , , , , ,

1 Comment »

  1. Wow that was odd. I just wrote an incredibly long comment but after
    I clicked submit my comment didn’t show up. Grrrr… well I’m not writing all that over again.
    Anyway, just wanted to say superb blog!

    Comment by Makrand Morar | July 30, 2012 | Reply

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