How Filing Bankruptcy Affects Cosigners

When someone agrees to cosign a loan, they are making a significant financial commitment. They are essentially promising to take responsibility for the debt if the primary borrower fails to meet their obligations. While this arrangement can help the primary borrower secure a loan or obtain better terms, it also carries risks, especially if the borrower files for bankruptcy. For cosigners, understanding how bankruptcy affects their financial standing is crucial to protecting their own interests. This article explores the various ways bankruptcy can impact cosigners, the potential legal ramifications, and strategies to mitigate these risks.

Understanding the Role of a Cosigner

A cosigner is an individual who agrees to share responsibility for a debt along with the primary borrower. Cosigners are often family members or close friends who have a stronger credit profile than the borrower. By cosigning, they provide additional assurance to the lender that the loan will be repaid.

However, cosigning comes with its own set of risks. If the primary borrower fails to make payments, the cosigner is legally obligated to step in. This financial relationship can become complicated if the borrower decides to file for bankruptcy, as creditors may shift their focus to the cosigner for repayment.

Types of Bankruptcy and Their Impact on Cosigners

Bankruptcy is designed to help individuals discharge or restructure their debts, but the way it affects cosigners depends on the type of bankruptcy filed. The two most common types of consumer bankruptcy are Chapter 7 and Chapter 13.

Chapter 7 Bankruptcy

Chapter 7 bankruptcy, also known as liquidation bankruptcy, allows the debtor to discharge most unsecured debts. For the primary borrower, this can provide a fresh financial start. However, the discharge only applies to the borrower—not the cosigner.

• Impact on Cosigners: If the borrower’s debt is discharged under Chapter 7, the creditor can still pursue the cosigner for repayment. This means that while the primary borrower is relieved of their financial obligation, the cosigner remains fully responsible for the remaining balance.
• Example Scenario: Suppose the primary borrower files for Chapter 7 bankruptcy to discharge a $10,000 personal loan. Once the debt is discharged, the creditor may turn to the cosigner to recover the entire amount.

Chapter 13 Bankruptcy

Chapter 13 bankruptcy, often referred to as reorganization bankruptcy, allows the debtor to repay their debts through a court-approved repayment plan over three to five years. Unlike Chapter 7, Chapter 13 offers some protection to cosigners.

• The “Cosigner Stay” Provision: Under Chapter 13, creditors are temporarily prohibited from pursuing cosigners while the borrower adheres to their repayment plan. However, this protection is not absolute. If the borrower fails to make payments as outlined in the plan, creditors may resume collection efforts against the cosigner.
• Limitations of Protection: The cosigner stay does not apply to all debts, particularly those incurred for business purposes. It also doesn’t eliminate the cosigner’s liability—it only delays potential collection efforts.

Creditor Actions Against Cosigners

When a borrower files for bankruptcy, creditors often shift their focus to the cosigner to recover the debt. Here are some common actions creditors may take:

1. Demand Letters: Cosigners may receive letters demanding immediate repayment of the outstanding balance.
2. Lawsuits: If the cosigner does not comply with repayment demands, creditors can file a lawsuit to collect the debt. This could lead to wage garnishments, asset seizures, or liens on the cosigner’s property.
3. Credit Reporting: Late payments or defaults by the primary borrower can negatively impact the cosigner’s credit score, even if they were unaware of the borrower’s financial struggles.

How Cosigners Can Protect Themselves

While cosigning a loan always carries some risk, there are steps cosigners can take to minimize their exposure:

1. Assess Financial Risks: Before agreeing to cosign, carefully evaluate the borrower’s ability to repay the loan. Ensure that you can comfortably cover the payments if necessary.
2. Monitor Payments: Stay informed about the borrower’s payment history. Request access to the account or periodic updates to ensure payments are being made on time.
3. Legal Advice: Consult with a financial or legal advisor before cosigning a loan. Understanding the legal implications can help you make an informed decision.
4. Insurance Policies: In some cases, purchasing credit insurance can help protect cosigners by covering payments if the borrower defaults.
5. Limit Exposure: Avoid cosigning for large loans or debts that would cause significant financial strain if you had to repay them.

Can Bankruptcy Help Cosigners?

In some cases, cosigners may find themselves in financial distress due to a borrower’s bankruptcy. When this happens, they might consider filing for bankruptcy themselves. Here are some scenarios where bankruptcy could provide relief:

• Chapter 7 Bankruptcy for Cosigners: If the cosigner qualifies, they may be able to discharge their responsibility for the debt.
• Chapter 13 Bankruptcy for Cosigners: Filing for Chapter 13 could allow the cosigner to reorganize their debts and create a manageable repayment plan.

However, filing for bankruptcy is a significant financial decision that should only be made after consulting with an experienced attorney.

Real-Life Examples and Lessons Learned

Consider the following case study:

• Case Study: A parent cosigned a $20,000 car loan for their child. After losing their job, the child filed for Chapter 7 bankruptcy and had the loan discharged. The creditor then pursued the parent for the full amount, leading to wage garnishment and financial hardship.
• Takeaway: This example underscores the importance of understanding the risks of cosigning and maintaining open communication with the borrower about their financial health.

Tips for Borrowers and Cosigners

For Borrowers:

• Be transparent with your cosigner about your financial situation.
• Explore alternatives to bankruptcy, such as debt consolidation or negotiation, to minimize the impact on your cosigner.

For Cosigners:

• Ask for written agreements or clauses that limit your liability in case of default.
• Avoid cosigning unless absolutely necessary and ensure you have the means to cover the debt if needed.

Conclusion

Filing for bankruptcy can provide relief for borrowers but often leaves cosigners vulnerable to financial repercussions. Whether through Chapter 7 or Chapter 13 bankruptcy, the effects on cosigners can range from creditor demands to legal actions and credit score damage. By understanding the potential risks and taking proactive measures, cosigners can protect themselves from undue financial hardship.

If you or someone you know is facing challenges related to bankruptcy and cosigning, it’s essential to seek professional legal advice. Contact McGuire Law Offices today for a consultation to explore your options and safeguard your financial future. Call us now at 402-965-0775.