What Happens when a Cosigner Declares Bankruptcy?

A cosigner's declaring bankruptcy can be a significant challenge for a borrower. Yet, it can also be a matter of little importance. The question of how the problem is handled falls mostly with the lender who holds the cosigned loan. If that lender poses simple alternatives to restructure the loan, there will be little consequence. If, however, the lender raises issue with the cosigner's case, then the borrower may have a very hard time keeping the loan in good standing.

When a Cosigner is Required

A cosigner is required when the primary borrower does not have a good enough credit score or high enough income to secure a loan. The cosigner allows the borrower to use his or her credit and income on the application. If the loan goes into default, the lender can hold the cosigner accountable. That being said, the borrower remains the primary borrower on the loan. The borrower is first responsible for making payments, and the borrower will be the one contacted if a payment is missed. The cosigner is not a joint holder of the debt.  

When a Cosigner Declares Bankruptcy

Because the cosigner is not a joint holder of the debt, the debt will not enter into any bankruptcy discussion on behalf of the cosigner. For example, the cosigner would not need to liquidate an asset to repay the cosigned loan. It is necessary, though, for the cosigner to be released of obligation to that loan. As long as the cosigner's name is on the debt, the bankruptcy cannot be completely satisfied. As such, the court, cosigner, borrower and lender will consider the options to remove the name from the debt.

Modifying the Cosigned Loan

The first option to remove a cosigner from a loan is to modify the debt. Here, there are a couple of strategies to consider. One strategy is to replace the original cosigner with a new cosigner of equal or better credit. Most lenders will allow a borrower to do this without too much hassle in this circumstance. The second option is to have no cosigner on the loan moving forward. This is only possible if the financial situation of the primary borrower has improved to a level that allows him or her to qualify for the loan outright. After years of making payments on an auto loan, for example, the borrower may be able to assume the loan fully. 

Closing the Cosigned Loan

The second option is to close the loan entirely. To do so, the primary borrower would have to pay off the loan. There may be prepayment fees associated with this decision. Once the loan is paid off, both parties are released of their obligation to the debt. The cosigner will not have to resolve this issue in the bankruptcy court. The primary borrower can walk away without further concern. This option is best if the borrower has the cash on hand to repay the loan outright and the penalty is not too high. It is the simplest way to resolve the issue.

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