A concern frequently expressed by debtors is whether their Bankruptcy filing will affect the credit of an individual who co-signed a loan for them. The following explains the impact on a co-signer’s credit if the debtor files for Chapter 7 Bankruptcy, and the impact on that credit if the debtor files for Chapter 13 Bankruptcy.If the Debtor files for Chapter 7 Bankruptcy:
As long as the debtor agrees to keep the co-signed loan, and the lender does not lose any money on the loan, the debtor’s filing for Bankruptcy will have no impact on the co-signer’s credit. In such a scenario, once the Bankruptcy is filed, the debtor’s attorney would contact the lender and obtain a reaffirmation agreement for the debtor’s signature. A reaffirmation agreement is a document which reinstates the loan as if the debtor had never filed for bankruptcy in the first place. Once the reaffirmation is signed and filed with the Court, the status of the co-signed loan is as if the debtor had never filed for bankruptcy and the co-signer’s credit remains unblemished.
If the debtor wishes to surrender the collateral for which the underlying loan was co-signed, then the lender, by law, must sell that collateral at auction and give the debtor credit for the sale price. This credit will reduce what the debtor owed overall on that collateral. The remaining balance is called a “deficiency balance”. (On occasion, the collateral might sell for more that what the debtor owed on it, in which case there would be a surplus which must be refunded to the debtor. In the event of a surplus, there would be no impact on the co-signer’s credit).
In the event of a deficiency balance, there will be an impact of the co-signer’s credit unless the debtor signs a reaffirmation agreement agreeing to pay the lender that deficiency in full. In such a case, the deficiency must be paid back with whatever the prevailing interest rate on the co-signed loan was. Otherwise, the co-signer would still be “on the hook” for the interest, and this would negatively impact his credit.If the Debtor files for Chapter 13 Bankruptcy:
In a Chapter 13 Bankruptcy, if the underlying loan is secured by collateral, the debtor has the option of either keeping or surrendering the underlying collateral. If the debtor keeps the underlying collateral and pays the balance owed in full, there would be no impact to the co-signer’s credit.
Sometimes, the debtor can keep the collateral but reduce what he owes on if by doing a “cramdown”. In a cramdown, the debtor pays back the “fair market value” of the collateral, which may not be the same as the amount owed on the collateral. For example, the debtor might owe $10,000 on a vehicle that has a fair market value of $6,000 on the day he files for Bankruptcy. In a Chapter 13 Bankruptcy, the debtor can reduce (cramdown) the $10,000 he owed on that vehicle at filing to the $6,000 that the vehicle is actually worth at filing.
If the debtor does a cramdown, the cosigner’s credit would be impacted as the loan would not be paid back in full. So the collateral must never be crammed down if the debtor wants to protect the co-signer.
If the debtor surrenders the collateral and does not make provision in the Chapter 13 to pay the deficiency balance in full, at the prevailing interest rate, then the co-signer’s credit will be negatively impacted. If the debtor agrees to pay the deficiency balance in full, at the prevailing interest rate, then there would be no impact on the co-signer’s credit.
If the co-signed loan is completely unsecured, 11 USC 1301(a) of the Bankruptcy Code will allow the Chapter 13 debtor to treat this debt differently from the other debts and allow the debtor to pay it back in full with interest, in which case there would be no negative consequences to the co-signer.