Understanding Personal Loans and Bankruptcy Risks: An Expert Analysis

This blog post summarizes the video that you can see below, which tackles one of the most difficult situations my clients face: the risks associated with personal loans between friends or family, especially when bankruptcy enters the picture. This issue is complicated, whether the debt is unsecured or secured.

By Alexander Hernandez, J.D., Professor, and Author of Consumer Bankruptcy Law (Routledge).

Updated on November 5, 2025.

Key Takeaways from Understanding Personal Loans and Bankruptcy Risks

• Preferential Transfers are Illegal: Repaying friends or family members before or outside of filing for bankruptcy is a serious legal violation called a Preferential Transfer. The bankruptcy trustee has the power to sue the friend or family member (the creditor) to recover the money.
• Expert Insight: This is not just a theoretical risk; this very issue caused Dr. Phil’s company bankruptcy to be converted from Chapter 11 to Chapter 7.
• Secure Your Loan Formally: Unsecured personal loans are almost certainly discharged (wiped out) in a Chapter 7 bankruptcy. To protect yourself, you must have a formal, written, and legally secured agreement.
• Experience Matters: Inexperienced attorneys may cite a two-year look-back period (based on federal fraudulent transfer forms), but this is wrong! Bankruptcy trustees routinely use state law to “claw back” funds.

The Risk: Preferential Transfers and Creditor-Debtor Law

Lending money to someone you care about can be stressful enough, but what happens if that person files for bankruptcy?

If the debtor includes you in the bankruptcy petition, that debt could be eliminated. However, many people choose to repay friends or family before or outside of the bankruptcy process to avoid this conflict. This seems kind, but it is illegal.

The Law: The Bankruptcy Code prohibits a debtor from giving preference to one creditor over another. If the trustee finds out you were repaid within the look-back period (typically 90 days for non-insiders, or up to one year for family/friends, who are considered “insiders”), the trustee has the legal power to sue your friend or family member (the creditor) to recover the funds for the bankruptcy estate.

This is known as a Preferential Transfer, and it creates far more legal trouble and awkward holiday dinners than simply listing the debt from the start. It was this same issue that caused “Dr. Phil’s” corporate bankruptcy to be converted from Chapter 11 to Chapter 7 (liquidation).

In Dr. Phil McGraw’s Merit Street Media bankruptcy filing, which resulted in a rare trial, the bankruptcy judge ruled that attempts were made to pay favored creditors. This was based on evidence presented to the court during the trial, which included deleted text messages from Dr. Phil. The court even referenced in its ruling that these were “gangster moves.” You can learn more about Dr. Phil’s case via this prior post and video.

The Look-Back Period. Where Experience Matters

It’s critical to understand that the trustee’s investigative reach is often longer than the one-year “insider” period you might read about.

• The Inexperienced Lawyer’s Blind Spot: You may be advised by an inexperienced bankruptcy attorney that the look-back period is only two years because this is the period referenced on the bankruptcy petition. This advice is dangerous and wrong!
• Strong Arm’s Clause §544(b): The bankruptcy trustee, under the authority of the Bankruptcy Code’s strong-arm clause, steps into the shoes of an unsecured creditor. This allows the trustee to use the state’s fraudulent transfer or voidable transaction laws, which commonly have look-back periods of four years or more.
• The Consequence: If you made a transfer to a friend or family member more than two years ago but less than the state’s four-year limit, the trustee can still sue the recipient to “claw back” the funds by using the longer state law. This is a crucial detail that bankrupt debtors and often their less-experienced attorneys miss.

If the trustee finds out, they will sue your friend for the funds. It’s not only the trustee’s obligation on behalf of the bankruptcy estate, but it’s also to the trustee’s financial benefit, as they will pursue fees as well.

I discuss this in detail in Chapter 2 of my bankruptcy law textbook: Overview of the Bankruptcy Code.

Secured vs. Unsecured Debt in Bankruptcy

When evaluating your risk as a lender, the legal category of the debt is everything.

Personal Loans and Unsecured Debt

Unsecured debt is not attached to any asset. As a result, it lacks legal protection, and no funds are likely to be recovered.

• In a Chapter 7 bankruptcy, this debt will almost certainly be wiped out (discharged). Since large corporate creditors like Capital One or Bank of America are likely owed much more, the small amount you loaned will probably yield little, if any, repayment from the bankruptcy estate if there are non-exempt assets.

Protecting Yourself with Secured Debt

The results are fundamentally different for secured debt. Secured creditors (like a bank holding a car title or a mortgage) are protected because their claim is attached to the collateral. Secured creditors are typically prioritized and paid first in a Chapter 13 bankruptcy.

The Takeaway: There is no difference between a major mortgage company and your best friend in the eyes of the law; they are all creditors. This is actually a good thing, as you are afforded the same protection as the big banks, provided your debt is properly secured.

The Professional Way to Secure a Personal Loan

How can you genuinely protect yourself when providing a loan? Formal documentation is non-negotiable.

• Best Practice: You need a formal written agreement that legally establishes your claim to collateral (e.g., a lien on a car, or a deed of trust/mortgage against real property). Simply having a signed IOU is often insufficient to establish a secured claim.
• Example: While complicated, I have seen agreements where a quit-claim deed was signed to transfer property ownership to the lender, with a separate agreement stating the deed would be destroyed upon full repayment. This extreme measure legally formalizes the security interest. In my experience, it also guarantees repayment.

The 341 Meeting: What to Expect as a Creditor

If you loaned money to the person now filing for bankruptcy, you will receive a notice for the 341 Meeting of Creditors.

• Your Role: You are not obligated to attend. This is an administrative meeting with the Bankruptcy Trustee, who has no authority to issue rulings or hear objections from creditors. The primary purpose is for the Trustee to verify the debtor’s identity and review the bankruptcy petition.

Tax Refunds and Attorney’s Fees

One common legal pitfall involves the debtor using assets (like a tax refund) to repay a friend immediately before filing.

• The Key Distinction: It is legally permissible for the debtor to use those funds to pay the bankruptcy lawyer first and then file the petition. This is viewed as a necessary professional service to initiate the process and avoid the legal headaches associated with preferential transfers.

The Professor’s Take: In conclusion, lending money to friends or family is risky. It not only presents the possibility that you have to sue a family member to collect on the debt, but if that family member files for bankruptcy, you will likely not be able to collect on the balance. If possible, consider written agreements where assets are used as collateral.

Colleges and universities can purchase my bankruptcy law textbook directly from Routledge Publishing. Paralegals and students who are buying single copies can do so via Amazon Books. To access my YouTube channel, click this link.

You can learn more about filing for bankruptcy and the bankruptcy petition via this link. Information on the bankruptcy court system, contact information for trustees, and your state’s exemptions can be found here. The federal bankruptcy exemptions are listed here. The latest version of the 341 Meeting of the Creditors can be found here.

You can find additional categories by clicking below or by using the search feature at the top of this page:

• Bankruptcy
• Insights & Analysis

Please note that the information on this site does not constitute legal advice and should be considered for informational purposes only.

Updated on April 30, 2025.