Chapter 7 bankruptcy is designed to allow individuals to obtain relief from their debts and make a fresh start through a discharge of their debts. However, a Chapter 7 discharge does not always allow debtors to completely eliminate their financial obligations. Instead, any assets that the debtor has that cannot be protected by exemption are sold, with the proceeds going to repay creditors ordered by a priority system designed to allow them to receive as much repayment as possible before a discharge is granted.
One of the steps in processing a petition for a Chapter 7 discharge is for creditors to file proofs of claim against the debtor. After creditors have filed their proofs of claim, their debts are divided into two categories: secured and unsecured. Unsecured debts include credit card bills, personal loans and bills directly owed to merchants that do not have collateral attached. This division determines which creditors receive priority treatment for payment after the debtor's nonexempt assets have been liquidated for cash.
Along with federal and state income taxes and child support obligations, secured creditors are placed in a priority category, which means that they are paid before unsecured creditors. Secured debt includes mortgages, car payments and financial obligations that are secured by goods or property. The legal term for the claim a creditor has against a secured property is called a lien. For instance, the lien a lender has against a debtor who borrowed money to buy a car is the car. If the debtor fails to make timely car payments, the creditor can -- and often does -- seize the car.
Undersecured Vs. Oversecured Creditors
Once creditors have been categorized, secured creditors are divided into two further categories: oversecured and undersecured. The amount of the lien that an oversecured creditor has against a debtor's property totals the full amount of the creditor's claim, while the lien to which an undersecured creditor is less than the full value of the creditor's claim. An example of an oversecured creditor would be a mortgage lender whose claim against a debtor's home was less than the equity the debtor had accumulated. On the other hand, if the debtor was underwater on a house mortgage, the house would be worth less than the amount of the mortgage, which means that the lien held by the mortgage lender was undersecured.
Payment and Discharge
Once creditors have been sorted into their proper categories, the trustee -- that is, the official assigned by the court to oversee the distribution of a debtor's liquidated assets to creditors -- begins the process of repayment. If the debtor's assets are sufficient to repay all creditors in full, then that's what happens. However, with Chapter 7 bankruptcy, many debtors have few or no assets, which means that there is frequently not enough cash to repay all creditors in full. In such instances, secured creditors frequently receive pennies on the dollar for what they are owed, while unsecured creditors receive nothing.