Payment to Secured Creditors in Bankruptcy

If a debtor in bankruptcy owes a debt, and the debt is secured by some kind of lien (like a mortgage), the claim is “secured.” That’s good, because effectively, secured claims get paid first in bankruptcy. The claim is secured, though, only to the extent that there is value in the secured asset above and beyond what’s already pledged to others.

Let’s try an example from divorce. Let’s say that Henry and June divorce, and Henry agrees to pay June $80,000 two years after their divorce is effective. Henry keeps the house. To secure the payment, June takes a second mortgage in the house, which is junior in priority to the first mortgage. The two years have now passed, the house is now worth $200,000, and the mortgage has a current balance of $160,000. Does June have a secured claim? If so, how large? Here’s where bankruptcy code section §506(a)steps in.

June has a secured claim in the amount of the excess of the value of the house over the value of the existing mortgage, or $40,000. June still has the $40,000 remainder of her claim, but it’s an unsecured claim.

Secured creditors holding a judicial lien (that is, a lien created by a judge rather than by agreement) can have their security interests devalued dramatically if the property secured (for example, a homestead) is the subject of an exemption. Congress has said (in 11 U.S.C. §522(f)(1)(A)) that the exemption must yield to a judicial lien to secure support obligations. A judicial lien to secure a claim in property division, though, could be reduced to allow the exemption to be effective.