Typically, filing for personal bankruptcy impacts only the person filing the bankruptcy case and the creditors affected. Even a non-filing spouse is generally not affected. That analysis changes, though, when the person considering bankruptcy has a loan or line of credit that was cosigned by a friend or relative.
What generally happens to a cosigner in a Chapter 7 bankruptcy case is much different–and much more problematic–than what you can typically expect in a Chapter 13 case. But, there are steps the debtor may be able to take under both chapters to protect the cosigner.
What is a Cosigner?
When most people think of a cosigner, they think about a person who has guaranteed the loan to help someone with less than perfect credit get approved. While it’s true that a cosigner boosts the borrower’s access to credit by signing the application and agreeing to be responsible for the debt, the cosigner’s role is different from a guarantor’s.
While a guarantor’s liability for the debt is triggered by the borrower’s default, the cosigner is on the hook from the beginning, jointly responsible for every loan payment. That means the debt may impact the cosigner’s access to credit even while the borrower’s payments are current, since it appears as an obligation on the cosigner’s credit report. And, any late payments are reflected on the cosigner’s credit history exactly as they are on the borrowers. If the borrower falls significantly behind on the loan, the creditor will likely pursue the cosigner for payment. And, he or she will be subject to the same types of collection action the borrower would be, including a lawsuit and possible wage garnishment.
In other words, agreeing to cosign for someone else’s loan is risky. In fact, California law requires lenders to provide a written warning to cosigners about the risks and obligations they are taking on.
What Happens to a Cosigner When the Borrower Files Chapter 7?
Chapter 7 bankruptcy is intended to wipe out unsecured debt, but only as to the bankruptcy petitioner. That can leave the cosigner holding the bag. Imagine, for instance, that the borrower’s mother cosigned for a $2,500 personal loan. The borrower paid off $500 of the loan, and then filed for Chapter 7 bankruptcy.
In most cases, an automatic stay would be entered as soon as the borrower filed bankruptcy, and the lender would no longer be able to contact the borrower about the loan. But, in a Chapter 7 case, the stay does not extend to the cosigner. So, while the borrower was enjoying the protection of the automatic stay, the creditor could pursue the cosigner for payment. Similarly, once the debt was discharged, the borrower would be forever free of the obligation to pay it. But, mom would remain obligated to pay the remaining balance unless she, too, filed bankruptcy.
Even if there are assets to be distributed to creditors in the Chapter 7 case–which is unusual–the cosigner’s claim would be subordinated to the creditor’s, meaning that he or she could not recover anything unless and until the creditor’s claim was paid in full.
In theory, the borrower could reaffirm the unsecured debt and continue to make payment. But, this isn’t always workable for the borrower, and may undermine the power of the fresh start bankruptcy is meant to offer.
Secured debt isn’t discharged in bankruptcy the way unsecured debt is. Instead, the borrower has three options: to reaffirm the debt and continue to make payments, to “redeem” the collateral with a lump sum payment, or to surrender the collateral and discharge any remaining balance.
Problems arise for the cosigner when the borrower decides to surrender the property and walk away from the debt. That’s because the property surrendered is often not worth enough to pay the remaining balance of the loan plus costs of the sale.
For example, the borrower may choose to surrender a car that is worth $12,000, but serves as security for a loan with a remaining balance of $17,000. Ordinarily, if the lender sold the car for $12,000, the borrower would be responsible for the remaining balance of $5,000, plus the lender’s expenses in repossessing and selling the vehicle. In Chapter 7 bankruptcy, the debtor is relieved of that obligation–any remaining balance is discharged. However, the discharge doesn’t impact the cosigner’s obligation. So, the lender can and likely will pursue the cosigner for payment of the remaining $5,000 plus expenses.
The bottom line is that Chapter 7 bankruptcy may not be the right choice for someone who has a cosigner and wants to protect the cosigner from continuing obligation for the debt.
What Happens to a Cosigner When the Borrower Files Chapter 13?
Unlike Chapter 7 bankruptcy, Chapter 13 bankruptcy is designed to allow filers to repay their debts over time. Because the creditor can generally expect repayment in a Chapter 13 case, the U.S. Bankruptcy Code provides greater protection for cosigners. Most significantly, the automatic stay that prevents creditors from taking collection action after the bankruptcy case is filed extends to most cosigners. That means the creditor can’t pursue the cosigner for payment while the borrower is working on his or her repayment plan and waiting for confirmation. The creditor may be granted relief from the stay and pursue the cosigner if the borrower’s plan does not include repayment of the debt. But, assuming that the borrower includes the debt in the Chapter 13 plan and makes payments as scheduled, the cosigner will be protected for the duration of the plan.
The Bottom Line on Filing Bankruptcy with Cosigners
Depending on the circumstances, there may be ways to protect a cosigner in Chapter 7 bankruptcy, or the borrower may determine that Chapter 13 is a better option. This is a decision best made with complete information, so a free consultation with an experienced bankruptcy attorney should be the first step. Get in touch to explore your options.