Definition and Examples of Preferred Debt
When an individual or company files for bankruptcy, they are required to settle preferred debts before other types of debts. The funds collected after liquidating assets are then used to pay off preferred debts. Any amount remaining (if any) can then go to settle other debts. There are several types of preferred debt, including taxes, preferred stock, employee wages, and home mortgages.
- Alternate name: Senior debt, priority claim, senior expense
Darren Nix, the founder of Steadily Landlord Insurance, shared an example of how settling preferred debts might work for a landlord.
“Let's say a landlord files for bankruptcy,” Nix said. “The first debts paid off (preferred debt) are frequently the primary residency. Other debts, especially those to investors and shareholders, are paid last in the bankruptcy.”
How Does Preferred Debt Work?
Contrary to what some might believe, bankruptcy doesn’t wipe away all of your debts. “Bankruptcies are more like a renegotiated payment plan for a bankruptcy,” Nix said. “When a person is bankrupt, their assets are liquidated to pay off their debts. Courts establish preferred debts as the debts that are paid off first in a bankruptcy.”
Since preferred debt has higher repayment priority than “junior” debts, it is considered to be of lower risk to the lender. To compensate for the higher risk, you will typically see higher interest rates on lower-priority debts, such as second mortgages.
To demonstrate the difference between preferred and lower-priority debts, consider this example:
Let’s say a corporation has preferred debt that totals $500,000 and lower-priority debt that totals $100,000. The corporation files for Chapter 7 bankruptcy, and must now liquidate its assets to pay down the debts.
After liquidation, the liquidated assets total only $525,000. First, $500,000 of it will go to fully repay the preferred debt. The remaining $25,000 will go to paying down only a quarter of the subordinated debt.
Types of Preferred Debt
There are several types of preferred debt. Some common ones include:
- Preferred stock
- Home equity loans and lines of credit
- Employee wages
- Child support
Preferred stock refers to equity ownerships that carry a senior claim to a business’s earnings and assets compared to common stock. If the company is undergoing liquidation, preferred stockholders must be repaid before common stockholders, including any accumulated dividends that were delayed. If nothing remains after the company settles its senior debts, common stockholders may not be paid.
Home equity loans and lines of credit
A home equity loan or home equity line of credit—also called a second mortgage—is considered subordinate to the first mortgage. If your home forecloses due to defaulting on your payments, the first mortgage is preferred debt and is paid off first. Any equity left over (if any) is used to repay the home equity loan.
The Internal Revenue Service (IRS) has the power to seize your wages, including entire bonuses if you do not pay your taxes. Part of our wages will be garnished until you arrange for another way to pay your overdue taxes or until the full amount is repaid.
In the event of a company’s liquidation, employee wages are considered preferred debt. Until all of the employees are paid in full, any proceeds from the liquidation can not be paid out to any officers, directors, or general managers.
Child support payments
Child support cannot be discharged, even after filing for bankruptcy. Individuals can have their wages garnished to be paid for child support. A court order can ensure the payment of child support by compelling the employer to garnish, or withhold, a certain amount from the individual’s paycheck.
What It Means for Individuals
As an investor, there are advantages to owning preferred stock over common stock. As a preferred stockholder, you have a senior claim on the earnings and assets of a business. This reduces your risk should the company file for bankruptcy. The company is obligated to pay you, a preferred stockholder, any delayed prior payments before paying the common stockholders.
If you're a homeowner, your home mortgage is typically preferred debt. If you file for bankruptcy under Chapter 13, you have an opportunity to stop foreclosure on your home and make up defaulted payments over time. The catch is that you need to fulfill all mortgage payments moving forward. If you want to keep your home, your mortgage payments are a top-priority expense.
- Preferred debt is debt that must be paid first in the event of bankruptcy.
- Types of preferred debts include taxes, employee wages, preferred stock, and home mortgages.
- Lower priority subordinated debts are repaid only after preferred debts are fulfilled.
- Depending on how much money remains after settling preferred debts, holders of lower-priority debts may not be repaid.