What Happens To Co-Signed Loans In Bankruptcy?

Co-signers (aka co-debtors) on debts in bankruptcy must be included in the bankruptcy petition.  There is a separate schedule provided to list them, Schedule H.  They will receive notice of the bankruptcy filing and have the right to participate in the case if they elect to.  While such participation is rare, it is usually ugly when it occurs, as it is usually an estranged or former spouse or business partner arguing that the debt should not be discharged because it is subject to a divorce decree or separation agreement or it was incurred through some sort of fraud or defalcation.  In most cases, co-signers do not participate in the bankruptcy, but the filing often leads to ill will between the filing party and the co-signer.  

When a bankruptcy case is filed, the Automatic Stay of Bankruptcy is triggered.  This is a powerful federal injunction against creditors that prohibits them from taking further collection action.  The Automatic Stay extends to protect co-signers initially, so when the case is filed, the creditors are not permitted to pursue the filing debtor or the non-filing co-debtors.  If the creditor wants to proceed against the co-signer, they must seek permission from the court to do so, which will usually be granted.  Otherwise, the creditor can simply wait until the bankruptcy is closed and discharged, then pursue their collection rights against the co-signer at will.  

In Chapter 7, assuming the debt is discharged at the end of the bankruptcy, the co-debtor remains liable.  The creditor is free to pursue collection of the debt from the co-signer.  In order to protect the co-signer, you must either reaffirm the debt in bankruptcy or pay it voluntarily after the discharge.  This is not limited by the type of debt, so if you have a co-debtor on a financed vehicle that you surrender, the co-debtor remains liable for any deficiency balance on the vehicle after it is sold by the creditor.  The co-signer can, of course, take possession of the vehicle and pay it on their own if they choose.

Chapter 13 provides you with a few more options to protect a co-signer.  First, the co-signer will remain protected by the Automatic Stay for the duration of the three-to-five-year bankruptcy unless the creditor requests that the court remove the protection.  Second, you can propose in your Chapter 13 repayment plan to pay the creditor in full under the terms of the original obligation.  This is very common for secured creditors, such as vehicle loans, where you want to keep the vehicle and protect the co-signer.  Keep in mind that if you modify the terms of the loan and pay anything less than the full amount of the contractual obligation, the creditor is not required to release the title to the vehicle and can collect any amount remaining due from the co-signer after the discharge.  You may also do this with unsecured debts, such as credit cards or personal loans, but the bankruptcy trustee and court will provide a lot more scrutiny on these efforts.  The general rule is that you must be able to successfully argue that the special treatment provided to the specific creditor is reasonable and necessary and does not substantially negatively impact the other creditors in the case.  This is not a fixed standard by any means and can be argued, but protecting a non-filing co-debtor is generally considered to be reasonable and necessary.  The challenge arises when you try to pay one creditor in full while paying pennies on the dollar to other creditors.