Issues of Personal Loans and Bankruptcy: What You Need to Know
Hi there. I’m Alex Hernandez, aka Professor Alex. Thank you for joining me today. Today, I will go over the issues of personal loans with friends or family members and bankruptcy. Personal loans could also result in issues with the trustee, as there can’t be favoritism with debt and creditors.
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Personal Loans and Bankruptcy
This is an issue because many times, a client may ask someone they know might ask if they can borrow money, whether it’s to pay for a bankruptcy lawyer or to get by that month and pay a couple of bills. The question that usually comes up is: What do I do about my friend?
Well, between you and me, if you put them on a bankruptcy petition, you’re probably not going to get invited to the next Sunday BBQ. Sometimes, a debtor may not include their friends or family on the bankruptcy petition and just pay them back. That’s not right since all creditors must be listed, but who’s going to know?
But what if a debtor does include them? What happens then, besides the awkward Thanksgiving dinner? You can also make plans for the next Super Bowl party since you won’t be invited. You can also count out the Fantasy Football League.
Secured versus Unsecured Loans
How do we handle this now? First, we have to understand the issues of secured and unsecured debt. You’re basically not protected if it’s unsecured debt, and you give someone a personal loan. That debt will get wiped out unless there’s money that’s part of the bankruptcy estate, where maybe all the creditors can get some portion of the balance paid off. But creditors only get a pro-rata share.
So, there’s a good chance that more money is owed to Capital One or Bank of America than to you. If you paid $500 to your friend, you won’t get much back in return with Chapter 7. If you do a Chapter 13, maybe. That gets complicated with a lot of other issues, but again, chances are you’re not going to get the full amount.
But what if it’s a secured debt? Do things change? Yes, absolutely. Secured debtors are protected. When Chapter 13 is filed, they’re the first paid out. Then, you have other priority claims like domestic support obligations (DSOs) and taxes. Then come the unsecured creditors. That’s how debts are paid back to creditors.
So, being a secured creditor, when you provide a personal loan, whether it’s your business or just something between friends, the question is: How do you protect yourself?
Protecting Yourself as a Creditor with Personal Loans
Well, it could get complicated. But realistically, you should be okay if it is a legitimate secured debt. I knew someone who used to do this. Who used to say, “Okay, I’ll loan you X amount, but we’re going to sign a quit claim deed”? Remember, that’s a transfer of an interest in the property.
They would say, “You’re going to keep my house for $5,000,” and the person would respond, “I’m not keeping your house if you pay me back.” Then they would say, “Well, I’m going to pay you back.”
“If that’s the case, then you will have no problems with the quit claim deed. But the only way I’m giving you the money is if you give me the title to the house. That’s the only way I can confirm that you’re actually going to pay.”
But how does it work with creditor and debtor law? How does this work with friends and personal loans? The answer is that creditors are creditors. It doesn’t matter if it’s your mortgage with Chase Bank, unsecured debt like a credit card (Capital One), or your best friend. They are all creditors in the eyes of the law.
Is there any difference between them? No. That’s why you don’t get to pick and choose which creditor to include on the bankruptcy petition. People say, “Oh, I want to keep this credit card because I like it. I have points.” It doesn’t work that way. You don’t get to keep it. All your debt has to be listed, and the debts that get discharged will get discharged.
What happens if you loaned your friend some money, and you get a notice for the 341 meeting of creditors? Do you have to go? No, this is not like your typical court hearing where you’re obligated to go, and if you don’t go, you won’t get in trouble with the judge.
In the first place, there is no judge. It is called a meeting of creditors. Do the creditors actually go? Not really. If there are any objections, it gets filed with the court because this is a quick 2-3 minute hearing where not much will happen.
But now the issue with friends is also, and you see this a lot with tax returns, that they receive a tax refund and say, “I’m going to use that money to pay my friend. I love my friend, have known him for twenty years, and I will use the rest of the money to pay the bankruptcy lawyer.” Is that a problem for your bankruptcy lawyer?
The short answer is no. You can pay your bankruptcy lawyer and file the petition the next day. The court’s not going to have a problem with that. Of course, lawyers are going to write laws to protect ourselves and our way of life. But it will affect your friend.
For example, I had a client who, at the 341 meeting, confirmed that they paid a debt to their friend from the tax refund. Again, creditors are all the same under creditor-debtor law. Everyone is treated the same. So, the fact that you paid a friend over another creditor will be an issue for the trustee because the trustee represents all creditors on behalf of the bankruptcy trustee.
For example, if you say, “I’m going to pay $5,000 to Capital One and then go ahead and file for bankruptcy.” Whoopsie. Yeah, there’s a good chance the trustee will contact Capital One and say, ‘Give me the $5,000, or I’m going to sue you.’ Between attorney fees and everything else, it could end up being $15,000. I’ve seen that happen before. Usually, the creditors cooperate in that regard.
But if you’re a friend or family member who loaned some money and your friend now filed for bankruptcy, you’ll probably get a phone call or a letter from the trustee saying, ‘Where’s my money? That belongs to the bankruptcy estate.’ At that point, if you received the money, you’ll have to give it back. “Too bad, so sad,” as one of my favorite law professors liked to say. That’s the way it works.
What typically happens is that debtors don’t want their friends to get sued, so they come up with the money themselves and pay the trustee. The trustee doesn’t care where the money comes from as long as they get it.
So keep that in mind: if you loan a friend money and they file for bankruptcy, you could be discharged in the bankruptcy. If you get paid first and then bankruptcy happens, that will also be an issue, whether you’re a debtor or a creditor.
All right, thank you, as always, for tuning in. As always, if you are a paralegal student using my textbook in your course, please chime in and put a question or comment in the section below. I’ll be more than happy to reply to you.
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This transcript was edited for clarity.
Updated on April 25, 2025.
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