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Understanding Bankruptcy and Cosigners

Posted by David Falvey on Wednesday, August 26th, 2015

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Chapter 13 Can Help Your Co-Signer and Protect Them

Often when someone applies for a loan, the loan applicant gets a cosigner to sign on it too. Sometimes this is because the applicant is young and needs a parent to back the loan. Other times, the business or person giving the loan wants someone with a stronger credit record to cosign the loan. When it comes to spouses, when one spouse signs, a creditor will often ask the other spouse to also sign on the loan.

Cosigners are great for getting the loan and the underlying collateral such as a car or a home. But complications arise when the loan goes into default. If this happens, the creditor will often proceed against the signer or cosigner who has the money or assets to pay the loan back.

Paying preferential treatments

Paying a cosigned debt ahead of other debts because the debtor doesn’t want the cosigner to be responsible, may be considered a preferential transfer. Bankruptcy trustees and judges may invalidate payments that were made prior to filing for bankruptcy that favors/prefers one creditor over another. This can be especially true if the bankruptcy filer pays a relative ahead of others. A bankruptcy lawyer will know the time limits and other preferential treatment factors.

Making payments in bankruptcy

If you’re in debt and have a cosigner you may want to make sure the cosigner is not held accountable. If you file a Chapter 7 bankruptcy, the creditor may agree to reaffirm the loan. A reaffirmation needs the consent of the creditor and the bankruptcy judge.

As long as there is a reasonable chance you can pay the reaffirmed debt, the creditor and judge will usually consent to the reaffirmation. Since your other debts are being discharged which frees up a lot of money, it is often the case that the you can reaffirm one or two smaller debts.

If you file a Chapter 13 bankruptcy, then, if the cosigned debt was collateral for a secured loan, the you can also agree to pay the cosigned loan by agreeing to pay the monthly instalments and the arrears. The arrears are paid over a three to five year period.

You will need to list any debts that are being cosigned. When you files for a Chapter 7 or Chapter 13 bankruptcy, all the debts should be listed in the initial bankruptcy filing so the trustee and the judge can be sure the resolution of the case treats all creditors fairly.

The creditor may try to collect against the cosigner

Debtors and cosigners need to know that if the debtor fails to pay the debt, then the creditor may try to collect against the cosigner. The cosigner does have some stake in what happens in the bankruptcy. If the debt obligation isn’t paid through a reaffirmation agreement or a Chapter 13 bankruptcy, then the cosigner may be a target.

For this reason, the cosigner may want to help the debtor by contributing some funds to allow the debtor to reaffirm or pay through the Chapter 13 plan.

The Co-debtor Stay

Chapter 13 does have an additional protection called the co-debtor stay. It’s part of Section 1301 of the US Bankruptcy Code. When someone files a bankruptcy petition, an automatic stay is created in favor of the debtor. This means all collection efforts such as calls, letters and legal actions must stop immediately. Creditors are required to process their claim through the bankruptcy court and through the bankruptcy trustee. This stay provision also applies to the cosigner with some exceptions.

The automatic stay does not apply to the co-debtor/co-signor if:

  • The co-debtor/co-signer became liable on, or secured such debt in the ordinary course of such individual’s business; or
  • the case is closed, dismissed, or converted to a case under chapter 7 or 11 of this title.

If the creditor requests relief from the stay through a court notice and hearing and if the court grants the relief, then the creditor can proceed against the debtor. The grant for relief (and the allowance to continue against the co-debtor/cosigner only applies if;

(1) As between the debtor and the co-debtor/co-signer, the co-debtor/co-signer received the consideration for the claim held by such creditor. This is an important point. Many cosigners did not receive consideration from the creditor.

(2) The plan filed by the debtor proposes not to pay such claim; or

(3) Such creditor’s interest would be irreparably harmed by continuation of such stay.

Again, the best way to protect a co-signer is to make sure the debt is paid through the Chapter 13 plan.

Credit Reports and Co-Signers

Any debtor who gets behind on his or her bills will likely face the prospect that a creditor will report the untimely payments or collection agents to one or all of the three major credit reporting agencies. Negative credit information stays on a person’s credit report for a period of years. The negative information can make it difficult to get a loan or mean that loans come with much higher interest payments

A debtor and his/her cosigner will be very concerned that the co-signer’s credit remain stable while the primary debtor is going through difficulty. This is true in and out of bankruptcy. It’s a prime reason why debtors make paying a debt that has a cosigner, a top priority. It’s also a reason why cosigner may agree to pay the loan – to protect his or her credit.

Secured debts that are co-signed are paid in full in a Chapter 13 so the cosigner’s credit should be OK if the debtor complies with the Chapter 13 plan. But what about unsecured debts? Normally debtors only pay a small percentage of the unsecured debt. This would mean the creditor would then come after the co-signer for the money. It also means the collection action would appear on the co-signer’s credit report.

Fortunately, the Chapter 13 bankruptcy law allows for an exception to the rule that not one unsecured creditor can be favored over another when it comes to co-signed debts. The debtor can agree, in a Chapter 13, to pay the unsecured debt that has a co-signer in full. This usually helps protect the co-signer and his/her credit rating.