Bankrupt? Pay your full car-loan debt anyway

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The law used to allow some people who filed for Chapter 13 bankruptcy to escape a portion of their auto loan debt, keep their vehicles and pay a lower monthly payment. The practice was called a “cram-down” in auto-lending parlance, and lenders didn’t like it at all.

Now, thanks to a little-noticed provision of the 2005 bankruptcy law revision, the crammer and the cramee have changed places. Filers who want to keep driving their vehicles must pay the total amount owed if they purchased their vehicles within the 30 months prior to filing, regardless of the vehicles’ actual values.

John Rao, staff attorney for the National Consumer Law Center, explains that before the law changed, if a consumer owed $10,000 on a loan for a car that was only worth $4,000, the creditor was paid $4,000 as a secured claim. Secured debt is debt backed by property that a creditor can seize if the debtor does not pay. The $6,000 difference became an unsecured claim, debt that the creditor has no assurance will get paid, and if it is, sometimes only at a rate of pennies on the dollar.

“The new law says that if it’s a fairly recent loan, the consumer may have to pay the $10,000 plus interest, that is the full balance owed, though the court may reduce the contract interest rate,” says Rao.

The rule does not apply if the consumer surrenders the vehicle as part of the Chapter 13 plan. But even surrendering the vehicle, as opposed to paying up what is owed, has been challenged in a Chapter 13 case at the U.S. Bankruptcy Court, Eastern District of Tennessee.

Bankruptcy attorney Tom Dickenson of Hodges, Doughty & Carson in Knoxville, Tenn., explains that Larry and Regina Ezell have offered to surrender their 2003 Nissan Xterra in a Chapter 13 case, in full satisfaction of any claim that the creditor, JP Morgan Chase Bank, might have. Dickenson, who represents a group of eight creditors from the state, argues that it can’t be done.

“What we’re saying is you can surrender the collateral (the vehicle), but if the collateral is sold and it doesn’t sell for enough to pay the debt in full, then we say the creditor is entitled to the unsecured claim.

“If the judge rules in favor of the debtor, what that would mean is all these people out there with car loans can file Chapter 13 and can just surrender vehicles in full satisfaction of the debt. One of the things we argued is that it will provide a windfall to debtors.

“I think this case could have an impact on future decisions.”

The National Automobile Dealers Association, or NADA, backed the new Chapter 13 provision. The association claimed in its legislative bulletin in March of last year that cram-downs, or court-ordered reductions of a secured balance, allow an individual to keep the vehicle and own it at a cheaper amount than a nonbankrupt consumer, and the cram-downs increased the price of secured credit.

The American Financial Services Association, a trade association for providers of financial services such as automobile loans to consumers and businesses, also opposes cram-downs, says spokeswoman Lynne Strang. She says some auto-finance borrowers declared bankruptcy to pay less than, or cram down, the amount they owed on an outstanding auto loan.

“Here’s a hypothetical example of what could be done prior to the law: A borrower could finance a car worth $20,000, then file for Chapter 13 bankruptcy a year later,” she says.

“At that point, the car may be worth only $12,000, but the borrower still owed $15,000 on his loan. Under the old system, the borrower would only have to claim $12,000 among obligations to be included in the Chapter 13 repayment schedule and get out of paying the $3,000 difference (between the car’s current value and what was still owed on the financing).”

Phil Corwin, who lobbied in support of the changed bankruptcy law, says he has heard time and time again that if the debtor’s current car was old and unreliable, bankruptcy attorneys would advise the client to go out and get a new car and good loan term before his or her credit was “trashed.”

“The abuse was the attorney advising the debtor that they would never have to pay the full purchase price of the new car because the amount owed could be crammed down by thousands of dollars after they filed for bankruptcy. So they purchased the vehicle with the intent that they would never pay thousands of dollars of the purchase price.”

According to Corwin, the anti-cram-down provision was initially put in the bill several years ago by former Sen. Spencer Abraham, a Republican from Michigan.

“He put it in the bill on behalf of the big three Michigan auto lenders (General Motors Corp., Ford Motor Co. and DaimlerChrysler AG), who felt they were being abused.”

He says the provision requiring a 30-month length of ownership of the vehicle prior to filing bankruptcy is understandable.

“By the time you have it for two-and-a-half years, the resale and the amount on the car note are pretty much going to be in sync.”

He adds that when the consumer keeps the vehicle longer, he or she generally will have more equity in it than the amount owed to the lender.

“You are going to get to the point where the car is worth more than what you owe the auto lender. You wouldn’t be eligible for a cram-down,” says Corwin.

Jack Nerad, executive editorial director and executive market analyst for and Kelley Blue Book, says situations vary. “It depends on the length of the loan term and the vehicle that you purchase. A lot of people would owe a lot more than what the car is worth two years into the loan.”

Nerad says the trend is to have longer loan terms and lower down payments.

“More people are upside down. They owe more on the car loan than the car is worth in the marketplace in the midst of the loan.”

If a person has equity in the vehicle, Rao says it’s unlikely that the consumer would give the vehicle back during the bankruptcy.

“The consumer would most likely pay off the balance owed in the Chapter 13 plan, assuming he or she can afford the plan payments.”

He argues that before the recent changes, the bankruptcy law tried to treat different creditors fairly. He says the law made sure secured creditors got paid based on the true value of the security, or property that can be claimed in the event the consumer defaults. This way, secured creditors did not get an unfair advantage over unsecured creditors.