Co-Signor Basics

If you’re trying to get a loan, but don’t have great credit, your lender might ask that your parents or a business partner co-sign on the loan. A co-signer usually will have good credit and agrees to make payments if you fall behind. In most cases, the borrower pays as agreed and the co-signor never comes into play. However, what happens when the primary borrower can’t afford to make payments and files for bankruptcy?

Bankruptcy Eliminates Personal Liability for Debt, But Only if You File…

To understand how bankruptcy impacts a co-signor of debt, you first need to understand what filing bankruptcy accomplishes. Bankruptcy doesn’t eliminate debt, it extinguishes personal liability for debt. Co-signing for debt is nothing more than attaching personal liability to a debt. A co-signor effectively says: “if she doesn’t pay, I will.” If you owe money jointly on a debt and file for bankruptcy, your co-signor will become fully responsible once you receive your discharge. The bankruptcy of one borrower does not relieve the liability of the other non-filing borrower.

Need an example? Let’s say you have a joint credit card account with a girlfriend. If you file for bankruptcy, your personal liability on the account will be discharged but your girlfriend’s liability will remain. The credit card company can then come after your girlfriend in a collection proceeding either through a debt collection company or in a lawsuit.

Can I Protect My Co-Signor?

If you’re going to be filing for chapter 7 bankruptcy, there is no inherent way to protect a co-signor. Unless the co-signor files bankruptcy as well, he or she will be liable for the debts you’re getting rid of. In addition, the automatic stay in a chapter 7 case does not protect co-signors. The automatic stay is an injunction, issued by the U.S. Bankruptcy Court, that prevents creditors from attempting to collect a debt once a bankruptcy case has been filed. The prohibition on collection activity is broad and applies to phone calls, foreclosure, lawsuits and even garnishments. The chapter 7 debtor will be shielded from creditors while their case is pending, but their co-signor will be fair game.

However, even in chapter 7 bankruptcy, one option that can afford protection for a co-signor is reaffirmation. Reaffirmation agreements are contracts that allow debtors to renew obligations on debts even after filing bankruptcy. In essence, you’re agreeing to a new contract to pay an old debt. In some cases, reaffirming a co-signed debt can prevent creditors from taking action against a co-signor. For more information see: Reaffirmation Agreements: the Legal Impact.

Chapter 13 Bankruptcy and Co-Signors

Unlike chapter 7 cases, chapter 13 bankruptcy provides protection for co-signors of consumer debts. Chapter 13 cases can last for between 3-5 years; in that time the automatic stay protects both the debtor and co-signor. While the automatic stay is in place, creditors will be prohibited from trying to collect on the co-signed debt from either party. However, when the debtors repayment plan does not pay the co-signed debt, the creditor can ask the court to have the automatic stay lifted so that they can come after the co-signor for the difference between what will be paid through the plan and what is owed. Perhaps an example will help clarify this technical area of the law:

Let’s say D owes C $200.00. D’s mother, M co-signed on the loan. Di files bankruptcy and proposes to pay each holder of an unsecured claim 70 cents on the dollar. C will thus be paid $140 under the plan. C can file a motion with the court to have the stay lifted so that she can collect the $60 from M.

In addition to situations where a creditor won’t be paid in full through a chapter 13 plan, creditors can seek to have the automatic stay lifted as to a co-signor where continuation of the stay would cause “irreparable harm” to the creditor. This will be a factual issue for the Judge. The point is to illustrate that, although the chapter 13 stay initially protects co-signors, there are ways for aggressive creditors to get around it.

The Bottom Line

When it comes to co-signors and bankruptcy, the bottom line is that chapter 13 bankruptcy provide far more protection than chapter 7. While chapter 7 bankruptcy will leave a co-signor completely exposed to collection efforts, chapter 13 will put the co-signor under the protection of the automatic stay for the period of time the case is pending (usually between 3-5 years) or until a creditor seeks to have it lifted. Ultimately, the best way to protect a co-signor is to keep up with payments as originally agreed, the bankruptcy court is far from a safe haven.

Jointly incurred debt is a complicated area of the law, if you have questions, consult an attorney.