Which Should I Do First: File for Bankruptcy or Buy a Car?

It's probably a better idea to wait until after your bankruptcy case ends before trying to purchase a car. However, sometimes that's just not feasible. In this article, you'll learn about the factors you'll want to consider before making the purchase, including:

• whether you can protect the amount you spend
• the type of bankruptcy you intend to file, and
• whether you need to purchase on credit.

(For a bankruptcy overview, read What Is the Difference Between Chapter 7 and Chapter 13 Bankruptcy?)

Can You Protect the Equity?

You don't lose all of your assets in bankruptcy. You're allowed to protect (exempt) what you'll need to get a fresh start after the case ends.

Each state has a list of property exemptions for its residents. In most states you can protect at least one car, but the amount of equity you can exempt is limited to a particular dollar amount.

If the equity in your car exceeds the exemption amount, what will happen to the car will depend on the chapter you file.

Chapter 7 bankruptcy. The Chapter 7 trustee will sell the car, give you your exemption amount, and use the remaining amount to pay fees and creditors—or force you to pay the nonexempt amount (usually with income made after the bankruptcy filing or money loaned from friends or family). The key problem you'll want to be aware of is that if you pay more cash for the car than you can protect with an exemption, you'll likely end up losing the car.

Chapter 13 bankruptcy. In a Chapter 13 case, nonexempt equity is handled a bit differently, but the result is similar. Specifically, the Chapter 13 trustee won't sell the car; however, you'll have to pay for the nonexempt portion of the vehicle in the three- to five-year repayment plan. If you don't have enough income to fund a plan that includes repayment of the nonexempt equity, you'll have to either:

• sell the car yourself (and likely turn over some of the proceeds to the trustee)
• let the car go back to the lender, or
• find a way other that Chapter 13 bankruptcy to handle your debt problems.

(To learn more about your state's exemptions, see Bankruptcy Exemptions by State.)

Red Flag: Converting Nonexempt Cash Into an Exempt Car

If you happen to have a large sum of money stashed somewhere, it might seem like a good idea to sink it into property that you can exempt, like a car. Why? Because most states don't have an exemption that will protect cash or money in a bank account (or it's very small).

However, you'll want to be wary of such maneuvers. Using nonexempt cash to purchase an exempt asset shortly before a bankruptcy case can raise a red flag (and the court will be aware of it because you'll have to report the transaction when filling out your bankruptcy paperwork). The bankruptcy court might interpret the transaction as an impermissible exemption-planning attempt designed to keep money that rightfully belongs to your creditors. If that's the case, you could lose the asset anyway.

Before taking such steps, it's prudent to speak with a local bankruptcy attorney familiar with the practices in your area.

Which Bankruptcy Chapter Will You File?

Chapter 7 and Chapter 13 bankruptcy treat secured debt—like car loans—in different ways. The consequences will also depend on whether the purchase occurs before or during a bankruptcy case.

• Buying a car before a Chapter 7 case. You'll probably have the fewest issues buying on a car on credit before filing bankruptcy, as long as your car isn't expensive and you didn't make a large down payment (see the exemption discussion above). The creditor will ask you to sign a reaffirmation agreement, which removes the loan from the bankruptcy case so that you'll continue to be responsible for payments after receiving your debt discharge.
• Buying a car before a Chapter 13 case. When you file a Chapter 13 bankruptcy, you'll propose a debt repayment plan to the court that will last for three to five years. If you purchase a car shortly before you file that Chapter 13 case, you probably won't be able to put your loan into your payment plan with your other creditors (unless your court has a rule that requires you to do so). You'll pay out your car loan according to its terms.
• Buying a car during a Chapter 13 case. You'll have a harder time replacing your car while you're in a Chapter 13 case. You can't just take on new debt to purchase another vehicle. If you need to buy on credit, you'll have to search for a lender that works with Chapter 13 debtors. (You can use this online tool to see if you qualify for a car loan after filing for bankruptcy.) You'll also have to get the approval of your Chapter 13 trustee and the bankruptcy judge and demonstrate that you have a good reason for buying a car, like to get to work. You'll also have to show that the cost and the loan terms are reasonable and that you can afford the payments and still make your Chapter 13 plan payment. You also won't be able to discharge (wipe out) any debt you take on while you're in Chapter 13 bankruptcy. (You can learn more at Your Car in Chapter 13 Bankruptcy: An Overview.)

(You can learn more about what you'll need to do to keep your car in Car Repossession & Bankruptcy.)

Buying a Car After Completing the Bankruptcy

Most people are concerned that the bankruptcy will prevent them from getting any new credit for a long time after the case ends. That's not usually the case. Many creditors, including car lenders, actively market to people who've just emerged from a successful bankruptcy case. They see a discharged debtor as a decent credit risk because you're restricted from filing another bankruptcy case and because you've wiped out other debt that was causing you financial pressure.

You can expect to pay a higher interest rate or a larger down payment. However, there's an upside: If you're careful about making your payments on time, the car loan can help you rebuild your credit. As your credit score rises, you'll be offered better terms on future car purchases.

You can learn more by reading Improving Credit after Bankruptcy or Foreclosure.