Co-signing a loan for a family member or friend is a nice gesture. The simple act of signing your name on the loan agreement will help them secure the financing they need to buy a new home, attend college, or even move into their first home.
However, what happens if the borrower files for bankruptcy? Are you still obligated to pay the loan? What happens to co-signed loans in bankruptcy in the first place? The answer is that your financial obligations as a co-signer don’t change if the primary borrower declares bankruptcy. You’re still responsible for repaying the entire loan.
In this article, we’ll explain the consequences for the co-signer if the primary borrower can’t make their payments anymore. We’ll also explore how the bankruptcy process impacts co-signers and what you can do to reduce your risk when helping someone qualify for financing.
What is a co-signer?
A co-signer is a person who agrees to share legal responsibility for paying off a loan if the primary borrower defaults on their payments. During the loan term, the co-signer has no financial obligations. But should the primary borrower fail to make their payments, the co-signer steps in to cover them, ensuring repayment of the debt.
Many lenders favour this arrangement as the co-signer provides extra security for the loan. This is especially true when the main borrower has poor credit or doesn’t meet the lender’s income requirements. By getting a co-signer to sign the loan contract, the borrower can qualify for the loan amount. They can also get a better interest rate and terms.
The risks of being a co-signer
Acting as a co-signer puts you in a precarious situation. The moment that you sign the agreement, you’re liable for the entire loan. That’s what makes co-signing such a risky decision.
Now, if all goes well, you won’t have to think about the loan whatsoever. The primary borrower will make all of their payments on time, paying off the entire loan on their own. But problems will emerge if they stop making the payments, for whatever reason. At this point, the lender will turn their attention to you. They will expect you to handle the regular payments, along with any interest and financial penalties.
What happens if you’re unable to take on these debt payments? In the eyes of the creditor, you’re equal to the primary borrower. As a result, you face the same consequences if you fail to repay the loan, as explained below.
Legal action. If you miss payment deadlines, the creditor can sue you to recover the money. They can garnish your wages, put a lien on your property, or freeze your bank account.
Negative credit impact. Missing debt payments as a co-signer can negatively affect your credit score. Since you’re accountable for the loan as the co-signer, the missed or late fees will appear on your credit report, bringing down your score. If the loan is sent to collections, you’ll get hit with an R9 rating, the worst one you can get on your report. This will hamper your ability to qualify for loans and obtain low interest rates.
Financial turmoil. The most significant risk with co-signing a loan is that it can ruin your financial stability. Managing someone else’s debt along with your obligations can be challenging and stressful. Considering the length of some loans — for instance, a mortgage on a house — you could be forced to juggle a lot of expenses for years of your life. It’s not sustainable. You can go deep into debt and become insolvent.
What happens if the primary borrower files for bankruptcy?
Let’s say the borrower that you’re helping is in deep financial trouble and decides to declare bankruptcy. So, what happens to you as the co-signer?
Under bankruptcy law in Canada, the primary borrower is released from any further obligation to pay unsecured debts. Some examples of unsecured debts are credit cards, payday loans, and lines of credit. However, this advantage doesn’t extend to you as a co-signer.
As the co-signer, you’re not off the hook because the primary borrower files for bankruptcy. The lender still retains the right to collect the money owed under the loan contract from the non-bankrupt party. The same principle applies in a consumer proposal, an alternative to bankruptcy in Canada—the co-signer remains responsible for 100% of the debt.
After the bankruptcy filing, the lender can freely pursue you for the entire loan amount. They can make collection calls, take you to court, and apply all kinds of pressure tactics (provided they’re legal, of course) to get you to pay.
It’s possible the bankruptcy may reduce the loan balance. But it’s not something that you, as the co-signer, should count on. Bankruptcy proceedings take a minimum of nine months to complete. In the meantime, the lender will expect you to continue making payments.
What happens if you file for bankruptcy?
If the primary borrower claims bankruptcy, you’ll be left to deal with the loan on your own. In this case, you might be unable to manage the payments and feel compelled to file for bankruptcy, too.
In that case, you’ll be legally absolved of the requirement to repay the loan (assuming it’s unsecured), just like the original borrower. However, you must be comfortable with some of the negative consequences of bankruptcy, such as giving up your assets and a decline in your credit score.
Luckily, there are plenty of assets you can keep under bankruptcy to maintain a reasonable lifestyle. You can also take steps right away to rebuild your credit after bankruptcy. The Licensed Insolvency Trustees at David Sklar & Associates can help you explore if this option is right for you.
How to protect yourself when co-signing a loan
Before signing the dotted line, assess the risk of co-signing a loan and take steps to lower your exposure. Doing so will minimize the chance of suffering credit damage, legal threats from creditors, and the burden of paying off another person’s debts.
Here are some ways to protect yourself as a co-signer:
Review the borrower’s financial health. Ensure the original borrower is financially reliable before agreeing to be a co-signer. Otherwise, there’s a good you’ll have to swoop in and bail them out. Some warning signs of poor financial health include:
- Dipping into their emergency fund or withdrawing from an RRSP to pay for debt
- Constantly taking out loans to cover regular expenses
- Frequently missing payment deadlines
- Reckless spending
If you can’t handle the risk or the borrower dodges your questions about their finances, gather the courage to say “no” when asked to be a co-signer. It’s in your best interest to do so. As a Licensed Insolvency firm with some of the top-rated bankruptcy trustees in Toronto and the GTA, we have seen many clients over the years who could have avoided bankruptcy if they had not acted as a co-signer on a loan.
Verify payments are made on time. Periodically check in with the borrower to ensure payments are being made. Encourage them to set up automatic payments to avoid missing deadlines. You can also request payment receipts from the lender to stay in the loop.
Get online access to the loan account. Request the borrower to give you access to their account. That way, you can monitor the status of the loan and make payments fast if needed.
Limit the time you stay on as a co-signer. Ask the lender if you can be released from the loan contract after a certain period.
Ask to be a co-owner of the asset. If the borrower has to put up an asset as collateral, request to be a co-owner. That way, you can sell the asset and use the proceeds to pay off the loan.
Review and retain a copy of the loan agreement. Ask the borrower for a copy of the loan agreement. Review the document for any special clauses to ensure you understand your responsibilities. You can also use it as evidence in court in case of a dispute.
Is there any way to get out of being a co-signer?
Yes. There are options to remove your name from a co-signed loan out there, depending on the type of loan you attached yourself to. Some loans have a co-signer release clause, which can free you after a certain number of payments. Another option is that the borrower can refinance the loan after some time and remove you from the new agreement.
Can you sue the primary borrower if they fail to repay their debt?
In general, you as the co-signer have no legal right to sue the primary borrower for debt payments they have to make on their behalf. The reason is that you agreed to share equal responsibility for the entire loan.
The only way you could take legal action against the original borrower is if you entered into a separate agreement with them. In this case, the contract would specify that they must reimburse you for any payments you make. If they fail to do so, you may have grounds to take the matter to court.
The bottom line on co-signed loans in bankruptcy
When you co-sign a loan for someone, you’re no different than a regular borrower from the perspective of the lender. So, if the primary borrowers stop paying, they will chase you for payment instead, including taking legal action like seizing your wages.
For this reason, avoid co-signing a loan unless you’re certain the borrower is trustworthy and financially dependable. You shouldn’t feel obligated to put yourself in a tough spot to make someone else happy. There are many ways to be helpful without co-signing, so work together to find a viable solution that doesn’t involve you taking on this burden. If the main roadblock is their bad credit score, suggest that they take time to fix that before seeking out another loan.
Have you co-signed an unsecured loan, such as a credit card, where the original borrower has filed for bankruptcy? If you’re unable to handle the payments, it’s time to explore your debt relief options. A Licensed Insolvency Trustee (LIT) is the best financial professional for getting advice on the best solution. Contact David Sklar & Associates today for a free consultation. We will review your situation and help you find the best path out of debt.
