As a bankruptcy attorney, I often encounter clients who have co-signed loans with family members, friends, or business partners. Although co-signing a debt for someone you know may come with good intentions, it is undisputed that is also comes with bad consequences. As such, co-signed loans can be a source of financial strain, and when bankruptcy is involved, it can become even more complicated. In this blog post, I will discuss the risks of co-signing a loan and how bankruptcy effects co-signed loans.
Consequences of Co-Signing a Debt
Before discussing how the filing of a bankruptcy can affect co-signers, it is essential to understand the concept of a co-signing a debt, and what it entails for both the borrower and the co-signer.
Co-signing a debt is a common practice that occurs when someone with a strong financial profile (i.e. high credit score/good credit history) agrees to add their name and financial information to a loan application to help someone else (with lower credit score/credit history) qualify for the loan or debt. As such, when co-signing for a loan or debt, a co-signer agrees to be legally responsible to pay the debt owed should the principal borrower fail to pay the debt.
Risks of Co-Signing a Debt
Before co-signing for someone, it is crucial to understand the risks involved. Here are some of the most important things to consider:
- You are fully responsible to pay the debt: As a co-signer, you are responsible for the entire loan amount, and any additional fees or collection costs that may arise if the borrower defaults on the payments.
- Your credit will be affected: When you co-sign a loan, both the loan and payment history show up on your credit reports as well as the borrower’s. This means that if the borrower misses a payment, it will negatively affect your credit score.
- Your access to credit may be affected: Co-signing a loan can also affect your ability to obtain credit in the future. This is because potential creditors will factor in the co-signed loan to calculate your total debt levels and may decide it’s too risky to extend you more credit (especially if the primary borrower is not paying on time).
- You could be sued by the lender: In some cases, the lender may pursue legal action against the co-signer if the borrower defaults on the loan. This could result in the co-signer being responsible for all costs associated with the debt, including attorney’s fees.
Bankruptcy and Co-Signed Debt
When one borrower files for bankruptcy, it can create a difficult and stressful situation for any co-signers involved. Co-signers may find themselves in a difficult situation because they will still be responsible for repaying the loan even though the primary borrower has filed for bankruptcy.
In some cases, bankruptcy may offer some relief for co-signers. However, and depending on the type of bankruptcy that is filed, will depend on whether the co-signer will be protected from creditors collecting on the debt.
For example, when a borrower files for Chapter 7, the co-signer that filed for bankruptcy (the “debtor”) is protected by the automatic stay which is a legal injunction that prevents creditors from taking collection actions against the debtor. Unfortunately for the co-signer (who is not in bankruptcy), there is no protection against creditor, and the creditor has an opportunity to collect the debt owed from the co-signer not in bankruptcy. This means that, even if the primary borrower's debt is eliminated in bankruptcy, the co-signer will still be on the hook for the debt.
Chapter 13 and the Co-Debtor Stay
On the other hand, Chapter 13 bankruptcy may provide relief for both the borrower and the co-signer. Under Bankruptcy Code Section 1301, co-debtors (co-signers) can benefit from the protection of the automatic stay during a Chapter 13 bankruptcy case. This particular provision is referred to as the "Co-Debtor Stay."
The Co-Debtor Stay is a temporary injunction that applies to any individual who is jointly liable for a debt with the debtor and is not filing for bankruptcy. Once the debtor files for Chapter 13 bankruptcy, this provision prohibits creditors from taking any collection actions against the co-signer. This means that, while the bankruptcy case is pending, the creditor cannot harass or sue the co-signer for payment of the debt. As such, the Co-Debtor Stay ensures that co-signers are not subjected to any undue pressure to pay the debt while the debtor is going through bankruptcy to potentially pay the debt.
However, it is important to note that, unlike the person filing bankruptcy, the Co-Debtor Stay does not discharge (or eliminate) the co-signer's liability for the debt. It merely provides temporary protection from collection actions during the bankruptcy case. If the debtor fails to complete the repayment plan, creditors may resume collection actions against the co-debtor.
For example, let's say that John and his sister, Sarah, co-signed a car loan for their cousin, Mike. Mike was making the loan payments on time for a while, but then he lost his job and started to fall behind on his payments. Eventually, Mike filed for Chapter 13 bankruptcy to reorganize his debts and come up with a repayment plan to pay back the amount he fell behind.
Under Section 1301 of the Bankruptcy Code, the Co-Debtor Stay would go into effect once Mike filed for Chapter 13 bankruptcy. This means that the lender would not be able to take any collection actions against John or Sarah while the bankruptcy case is pending.
Nevertheless, it's important to note that the Co-Debtor Stay does not mean that John and Sarah are no longer obligated to pay back the car loan. All this means is that, as long as Mike continues to make the necessary payments, the creditor cannot pursue John and Sarah for the repayment of the loan. On the other hand, if Mike stops making payments on the car loan and/or his bankruptcy case is dismissed before the case is completed, the Co-Debtor stay is no longer applicable, and the creditor can come after John and Sarah for the repayment of the car loan.
The following websites offer valuable resources regarding the effects of bankruptcy and co-signed loans:
- Federal Student Aid - What Happens If You Default on Your Student Loans? https://studentaid.gov/manage-loans/default#co-borrower
- S. Courts - Bankruptcy Basics: https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics
- Cornell Law School - Bankruptcy Law: https://www.law.cornell.edu/wex/bankruptcy
- United States Trustee Program - Bankruptcy Information Sheet: https://www.justice.gov/ust/bankruptcy-information-sheet
- American Bankruptcy Institute: https://www.abi.org/
- org - Bankruptcy: https://www.debt.org/bankruptcy/
Conclusion
Personal bankruptcy can have a significant impact on a co-signer and the underlying debt. Therefore, it is important to seek professional guidance and understand the potential consequences before filing for bankruptcy. If you are in debt, and need someone to explain how bankruptcy works and how the bankruptcy could impact the co-signer of a loan, we are well qualified as a full-service law firm for people in this county and other New Jersey counties: Passaic County, Hudson County, Essex County, Bergen County, Morris County, Union County, and Sussex County. Call us today at 973-554-9827 or toll free 973-696-8391.
