What Happens to a Cosigned Loan in a Bankruptcy?

by John Cromwell
Co-signing a loan carries the risk of having to pay the debt if the primary signer declares bankruptcy.

Co-signing a loan carries the risk of having to pay the debt if the primary signer declares bankruptcy.

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When a debtor goes into bankruptcy, the people he owes money to are concerned that they will not receive what is owed them. One possible source of security for the creditor is the existence of a co-signer who is not going bankrupt. When someone co-signs a loan, he is obligated to step in and pay the outstanding loan if the primary borrower cannot meet his obligations. Courts are focused on the debtor’s financial obligations during bankruptcy, but the fact that a debt may be co-signed can make the bankruptcy process a little more complicated.

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Chapter 7 vs. Chapter 13

Under Chapter 7 bankruptcy, a debtor must sell some of his assets to pay off his debts. Some of his assets, such as his home and the tools of his trade, are exempt from being sold. This is to ensure that the debtor has enough assets to sustain himself after the bankruptcy process. Once the sale is complete, the proceeds go to his creditors and any remaining debts are absolved. Chapter 13 does not require the debtor to sell any of his assets. The debtor must present a repayment plan, based on his employment and assets, which pays off what he owes. Generally, this plan takes three to five years to complete. If the plan is approved by the court and the debtor complies with it, at the end of the process the debtor is absolved from any remaining obligations.

Co-Signed Loan in Chapter 7

When a person files for bankruptcy, his creditors cannot come after him to repay the loan while he is going through the process. The debtor’s co-signer is not afforded similar protection. Under Chapter 7, a co-signer is still responsible to pay the entirety of the outstanding liability regardless of the debtor’s financial condition. In this scenario, the debtor should include the debt on his bankruptcy petition and the co-signer as a creditor. This way, the co-signer can get a portion of the proceeds from the bankruptcy to minimize her loss from having to pay the whole debt.

Co-Signed Loan in Chapter 13

Chapter 13 bankruptcy is better for co-signers since they are protected from having to pay the debt immediately. The bankruptcy court will issue a stay for the co-signer, since under the Chapter 13 repayment plan, the original debtor will have a means to repay the debt without the co-signer having to do it. Generally, the co-signer is only on the hook if the debtor fails in following through on his repayment plan. Once the co-signed debt is paid off in its entirety, the co-signer is absolved from any remaining legal liability for the debt.

Adversary Proceeding

Even under Chapter 13, a creditor may attempt to lift the stay for the co-signer. The creditor may only do this if the co-signer actually received the property the debt was used to obtain, the repayment plan does not include payment of the debt owed to the creditor, or the stay would hurt the creditor. An example of how a stay could hurt a creditor would be if the debt is on a car, which is rapidly depreciating. By revoking the stay, the creditor could take back the car to resell it, minimizing the potential loss. If the court agrees, it may lift the stay and the creditor can attempt to obtain what it is owed from the co-signer.