If you are filing for bankruptcy, you may be considering repaying certain debts before you file. Although paying off debts before filing bankruptcy may seem like the right thing to do, it is often not a good idea. In many cases, if you repay a debt within three months before filing (longer if the debt was to a family member or close friend), the bankruptcy trustee can sue the creditor to get the money back (called a clawback suit).
If you file for bankruptcy, at the end of your case you will receive a discharge. A discharge is a court order wiping out most or all of your debts (some types of debts cannot be eliminated in bankruptcy). (Learn more about which debts are discharged in bankruptcy.)
Sometimes a consumer doesn't want a particular debt to be wiped out, and is tempted to pay it before filing bankruptcy. Some common situations where a consumer might want to pay off a debt before filing include:
Many of the reasons that people want to repay debts are based on a misunderstanding of how bankruptcy works. For example, you might not automatically lose your home or car just by filing bankruptcy. And most credit card companies will become aware of your bankruptcy filing, even if you don’t have an outstanding debt with it and don't list the debt in the bankruptcy.
Paying debts off before filing bankruptcy can lead to problems once the case is filed.
Paying off a debt before filing your bankruptcy can cause problems for you and the person or business that you paid.
When you file for bankruptcy, a bankruptcy trustee will be appointed. The trustee’s job is to fairly distribute your assets and property, if any, among your creditors. (You don't have to give up all of your property during bankruptcy, learn what you can and cannot keep in bankruptcy.) The goal is to ensure that no one creditor has an unfair advantage over another.
If you pay a creditor within a short period of time before your bankruptcy, the court may consider that payment to be a “preferential transfer.” Because you pay that one creditor 100% of the debt owed, and then have less assets left to repay other creditors through your bankruptcy, you have "preferred" that creditor over the others. If that happens, the trustee can try to get the money back through a clawback action.
If you have made a preferential transfer to a creditor within the 90 days before you filed for bankruptcy, the trustee can file a clawback suit and try to obtain the funds from the paid creditor. If you repaid a close friend or family member, sometimes referred to as an “insider,” the time period that a court will consider extends to a year before you filed.
In a clawback suit, the trustee brings a lawsuit against the creditor that you paid off in order to get the money back. (Learn more about clawbacks and preferntial transfers in bankruptcy.) A clawback suit can cause several problems with your bankruptcy.
Not all prebankruptcy payments will be considered to be preferential transfers. You can make payments on debts if normally make such payments. The key is to not pay any more than you have been paying towards that debt.
For example, if you regularly pay your physician $100 a month to repay a larger medical debt, you may continue to do so. You can continue to pay your regular car payment, mortgage, child support, or student loans. You can also pay credit card debt that you recently incurred to purchase regular necessities of life, such as gas or food.
If you want to ensure that a creditor gets paid, the best way to do this is after the bankruptcy. There is nothing that prevents you from paying off a creditor, even if its debt has been discharged in the bankruptcy.
This is best done when you want to repay friends, family members, employers, or medical providers. However, many financial institutions and credit cards may refuse your payment after a bankruptcy discharge has been entered.