What Is Preferred Debt?
Preferred debt is a financial obligation that's considered more important than—or takes priority over—other types of debt. This type of debt obligation typically has to be paid first because it carries more significance. Interest on preferred debt is typically free from taxes. Preferred debt can also be referred to as senior debt in a corporate bankruptcy.
Understanding Preferred Debt
The main types of preferred debt include interest on mortgages, equity loans, and equity lines of credit. Any taxes owed to the Internal Revenue Service (IRS) are considered a form of preferred debt as well.
In a bankruptcy proceeding, the holders of mortgages and other forms of preferred debt are typically classified as secured creditors. Designation as a secured creditor often means there is a physical piece of property from which the debt is derived, such as real estate, in conjunction with a mortgage. In the liquidation of a debtor’s assets during a bankruptcy proceeding, the obligations of preferred debt must be discharged first. Loans of vehicles could also qualify the title holder as a secured creditor, with the outstanding obligation possibly qualifying as preferred debt.
With preferred debt based on physical property, it might be possible to recoup some, if not all, of the owed value by repossessing the property. For instance, a home or car could be seized and resold to pay off the debt. It is possible that the real property no longer holds enough value to cover the related debt. If this is the case, the holder of the preferred debt might seek to claim a portion of the cash assets that remain from the borrower as the liquidation proceeds.
Depending on what assets are available, it is possible that recompense for preferred debt leaves no capital to pay other subordinate debts or shareholders in liquidation. Even preferred securities are placed after preferred and senior debt in terms of repayment order. Preferred securities would still be paid before common shareholders receive any compensation. The amount of preferred debt that a company carries on its books, along with other liabilities, could affect its overall valuation and ability to secure additional financing.
Those who own preferred debt, such as the holder of a first mortgage, are in a greater position to see a return on the financing. This makes ownership of preferred debt more lucrative than owning subordinate, secondary debt.
In a Bankruptcy, Which Debts Will Be Paid First?
In a bankruptcy, secured creditors will always be paid first. A secured creditor could be your mortgage lender or someone who holds a physical property, such as a car, boat, or other form of real estate.1
Can Bankruptcy Clear My Alimony or Child Support Debts?
No, bankruptcy cannot clear alimony or child support debts. Any marital or child support agreements are considered nondischargeable debt and must be paid, regardless of other rulings.2
Can My Student Loans Be Discharged in Bankruptcy?
Student loans are very difficult, but not impossible, to get discharged in bankruptcy. To attempt a discharge, the filer must file an additional suit within their bankruptcy suit called an adversary proceeding. This is to show that repaying the student loans will cause undue financial hardship.3
The Bottom Line
One of the benefits of secured debts is a greater likelihood of repayment, even in bankruptcy. If you have a mortgage, car loan, or other secured debt, that will likely be the first debt to be repaid in a bankruptcy case.
