Paying down or paying off your car loan before you filing your case can pose a problem if you pay more than a normal monthly payment. Anytime you pay a creditor more than a regular monthly payment within 90 days of filing your case, the payment can be considered a preference. It is called a preference because by making the payment you are preferring one of your creditors over the others. The trustee can recover the preference payment and divide it equally, pro rata, amongst all of your creditors, which, under bankruptcy law, is considered to be a more fair result.
Can I Pay Off or Pay Down a Car Loan Before Bankruptcy?
Whether you can pay down or pay off a car loan before bankruptcy depends on whether your lender is fully secured or partially unsecured. If your lender is fully a secured creditor, you can pay as much of the loan off as you like before bankruptcy and it will not be considered a preference. If your car loan lender is partially unsecured, any amounts paid over and above the value of the vehicle will be considered preference payments, because that would result in the car loan lender receiving more than it would receive in a Chapter 7 liquidation scenario. The payments will be recovered by the trustee and divided pro rate among your creditors.
Fully Secured Creditor
Under the preference provisions of the bankruptcy code, one of the elements of a preference is that the creditor must receive more than it would receive in a Chapter 7 liquidation scenario had the preference payment not been made. Therefore, payment to a fully secured creditor is not a preference at all since the payment does not result in the creditor receiving more than they would receive in a Chapter 7 liquidation.
Partially Secured Creditor
A partially secured (or an undersecured creditor) would not be able to receive the full amount of its claim in a Chapter 7 liquidation, assuming there is no distribution to unsecured creditors. Put another way, the partially secured creditor really has two claims, a secured claim for the value of its collateral, and an unsecured claim for the remaining balance of the loan. In a Chapter 7 liquidation with no payment to unsecured creditors, the partially secured creditor would only receive the value of its secured claim, by repossessing and selling is security collateral.
Payments On Unsecured Portion
To the extent that the unsecured car loan lender receives payments on the unsecured portion of its claim, the payments would be a preference. Once the loan is paid down to the value of the vehicle such that the creditor is full secured, any further payments are not preference payments.
The further payment is not a preference because it does not result in the creditor receiving more than it would in a hypothetical Chapter 7 liquidation.
Pro Rata Distribution
Pro rata distribution can mean essentially losing all of the money you paid to your car loan lender. Because a vehicle loan will typically comprise only a small portion of your total debt, when the recovered preference funds are divided pro rata among your creditors your car loan lender will receive on a small part of the preference payment. The rest will go to your other creditors. This is in contrast to paying down a mortgage loan before bankruptcy, in which most of the money will usually go right back to your mortgage lender.