Should I start paying off some of my creditors before I file bankruptcy?


By the time you are ready to file bankruptcy, you have realized that your financial situation is a mess, and you have probably developed a plan to deal with those creditors.  If you’re here, then bankruptcy is part of a plan.  Personally, I love using the Dave Ramsey “debt snowball” plan, where you keep making monthly payments on each debt, and when you’ve paid off the smallest one, you apply those payments to the next smallest one, creating a snowball of debt repayment that focuses a larger and larger payment on each of your debts in turn.

However, in bankruptcy, you face a few problems with this.

First, you may be paying off a debt that won’t survive your bankruptcy.

Yesterday, I met with a client who had minimal credit card debt, $348 of tax debt from 2008, and about $820,000 of medical debt due to a four week stay in the intensive care unit of one of our local hospitals.  Yes, $820,000!  He was hit by a drunk driver at night-time and lay in the street for hours until the sun came up and morning commuters found him blocking their paths with his body.  He was ready to go bankrupt and get his life back in order, and in anticipation of meeting with me, he had just paid off that $348 tax debt.  I didn’t have the heart to tell him that those taxes were old enough to be dischargeable, and he had just thrown $348 away.  I know, it’s not a lot of money, but it was a lot of money to him.

Second, you may be opening up your creditors to a lawsuit from the bankruptcy trustee.

A bankruptcy trustee can sue your creditors under a preferential transfer action if you made a large enough payment to them prior to filing bankruptcy.  Basically, this means that you preferred one creditor over all of the others, and it isn’t fair.  This normally happens when you pay Mom and Dad back that $1,000 they gave you to cover rent.  This opens up Mom and Dad to a lawsuit from the trustee for $1,000.  You can pay ongoing bills like cell phones, rent, insurance, but payments to most creditors will come under scrutiny from the trustee.

Third, you may be exposing your assets to the trustee.

Too many clients love to pay off their car loans first so that they own the vehicle free and clear and can carry a cheaper insurance policy on the vehicle.  Unfortunately, if you pay off the car, you may now have too much equity in the car, and you might lose it to the trustee in bankruptcy.  Make regular payments, but don’t lump-sum pay it off.  Additionally, if we still owe some money on the car when you go bankruptcy, you can reaffirm the debt (keep it), and you’ll get some positive credit reporting after your bankruptcy.

It is a great idea to manage your finances and organize debt repayment, but if you’re going bankruptcy, talk to your attorney.  Even better, talk to your attorney and then plan on starting the repayment plans AFTER you have filed bankruptcy.