Many people incorrectly think that if they file for bankruptcy, they have to give up everything they own, including their car. This is not correct. Under both the bankruptcy law and Arizona law, a person filing for bankruptcy can keep many types of property, up to a certain value. These are called exemptions (See What is Exempt and Non-Exempt Property). In Arizona, this includes a car with equity up to six thousand dollars ($6,000), or twelve thousand ($12,000) for disabled individuals. So, if you have a car that’s paid off, and its value is no more than six thousand dollar, you get to keep it in bankruptcy no questions asked.
What if your car is not paid off, and you are still making payments on it? To determine if the car is protected, you have to figure out how much equity you have in the car. Equity is simply the value of the car minus the current loan balance. If your equity is six thousand or less (twelve thousand for disabled individuals), your car is protected.
Now, you may ask, what about the loan, won’t the lender take the car? This is where things get slightly more complicated, but the short answer is that you can keep the car even if there is a loan on it. Let’s break this down in more detail:
Do I have to pay the car loan after I file for Chapter 7 bankruptcy?
The answer is both no and yes, depending on your goals. The answer is no because Chapter 7 bankruptcy eliminates your personal liability for most types of debt, including car loans. This means that you no longer have any personal obligation to pay the car loan, and if you stop paying, the lender cannot come after you for the unpaid amount.
On the other hand, the car loan is a secured debt, meaning that the lender has a lien on the car to protect it against nonpayment of the loan. The car is the “collateral” for the car loan. If a secured debt is not paid, the lender can recover what it’s owed by taking the collateral and selling it. So, if a car loan is not paid, the lender can take the car, sell it, and get paid that way. Chapter 7 bankruptcy does not eliminate liens such as car loans, so if the car payments stop, the lender is able to take the car and sell it.
This means that if you don’t want to keep the car that is subject to a car loan, all you have to do in Chapter 7 bankruptcy is stop making payments on the car, and eventually the lender will repossess it. You will not be responsible for any unpaid balance on the car loan. This approach may make sense if you don’t have any equity in the car, or if you don’t want to keep the car for any other reason—for example, if the maintenance and repair costs are too high.
Can I keep the car in Chapter 7 if I continue paying the car loan?
It seems pretty straightforward to conclude that if you want to keep your car and it has a loan on it, you will have to keep paying the loan on the car. And in some cases this is all that is required. But, in many cases, just continuing payments will not be sufficient by itself. There are two related reasons for this. The first is that many car loan contracts provide that filing for bankruptcy is an event of default. In other words, you breach the loan contract by filing for bankruptcy, and the lender can then repossess the car. The bankruptcy law makes most such default provisions invalid. But, when it comes to car loan contracts, the rule is the exact opposite, and the lender can consider you in default if you file for bankruptcy, and repossess the car even if you continue making your payments.
How to use a reaffirmation agreement to keep a car in Chapter 7 bankruptcy
The bankruptcy law provides an exception to the above rule: if you sign a “reaffirmation agreement,” the lender cannot consider you in default and repossess the car just because you filed for bankruptcy. So what is a “reaffirmation agreement?”
A reaffirmation agreement is a document that states that you are agreeing to be responsible for a debt after bankruptcy. So, if you sign a reaffirmation agreement for the car loan, the agreement gets approved, and you later stop payments on the loan, the lender can sue and recover from you any money still owed on the loan. Remember that normally the lender would not be able to do this, because Chapter 7 bankruptcy eliminates your personal liability on the car loan.
The way to ensure that you can keep a car in Chapter 7 bankruptcy, then, is to sign a reaffirmation agreement, and to comply with the other requirements of the loan contract, which usually include making timely payments and keeping the car insured. If you do these three things—timely sign a reaffirmation agreement, keep making your payments, and keep the car insured—you can keep the car after Chapter 7 bankruptcy.
Of course, the negative consequence of an approved reaffirmation agreement is that if something happens down the road, and keeping the car no longer makes sense, you are still personally responsible for the loan. Luckily, at least in Arizona, there is a way to avoid this negative consequence of a reaffirmation agreement. Under the bankruptcy law, your only obligation is to sign the reaffirmation agreement. There is no requirement that the reaffirmation agreement be approved. The only way for a reaffirmation agreement to get approved is if your lawyer approves it, or if the bankruptcy judge approves it. Therefore, while you generally will want to sign the reaffirmation agreement if you want to keep your car, it is usually to your benefit to not have the reaffirmation agreement approved. That way, you have complied with your obligations and can keep the car, but if later on you determine that keeping the car is no longer in your best interest, you can give up the car and not have any personal liability for the remainder of the loan.
There are exceptions to this general approach, such as when the lender makes significant concessions on the interest rate or the principal in the reaffirmation agreement, so it is best to get competent legal advice before deciding how best to deal with a reaffirmation agreement (Read Should I Hire a Bankruptcy Attorney?)
You may also be interested in learning about the mistakes to avoid when filing for bankruptcy, and how different types of property are treated in bankruptcy.