When you cosign a loan, you agree to be responsible if the primary borrower does not pay, sometimes even after the borrower declares bankruptcy.

Cosigning for a car or other loan is different than co-borrowing or guaranteeing the loan. As a cosigner, you are fully liable for each payment (up to the entire balance of the loan) if the primary borrower defaults even though cosigners have no ownership rights.

Creditors can demand payment from cosigners without first exhausting collection remedies against the primary borrower and can report late payments to the credit bureau to negatively impact the cosigner’s credit score.

Conversely, an individual who guarantees a loan — sometimes called a “guarantor” — usually is only liable for the balance of the loan after the lender has tried to collect from the primary borrower.

How Repossession Affects Cosigners

When an auto loan defaults, lenders usually have the right to repossess the automobile. After repossession, the lender sells the vehicle, usually by public auction.

The difference between the sale price and the loan balance is called a deficiency balance. Creditors may file a lawsuit against borrowers and cosigners to collect the deficiency balance.

You may be wondering what stops creditors from selling the automobile for a ridiculously low price if they can sue for the deficiency balance anyway.

This is a legitimate question. The law requires creditors who repossess a car to sell the car in a “commercially reasonable manner.” This essentially means the creditor must act in good faith and follow ordinary local practices others would follow to sell a preowned automobile.

Usually this means the creditor must take reasonable steps to market the automobile to prospective buyers and advertise the auction where it is to be sold.

Still, automobiles usually sell at auction for much less than other methods of sale and this means the borrower and the cosigner will be financially responsible for a deficiency balance.

If a creditor acts unfairly in the sale of the automobile, this may create a legal defense the borrower and cosigner can use against collection of the deficiency.

Bankruptcy and Cosigners

Another way borrowers can protect themselves and sometimes cosigners from the deficiency balance is to file bankruptcy.

When a borrower declares bankruptcy, it eliminates his or her legal obligation to repay the automobile loan. Bankruptcy alone does not automatically stop repossession of the car, but it will prevent the creditor from collecting a deficiency balance from the borrower.

How the borrower’s bankruptcy affects cosigners depends on the chapter filed and whether the borrower retains the automobile.

If the borrower files chapter 7 bankruptcy and surrenders the car to repossession, the creditor still can collect the deficiency balance against the cosigner or guarantor. Chapter 13 bankruptcy offers a “codebtor stay” that prevents most creditors from collecting debts against cosigners and guarantors.

If the borrower files bankruptcy and wants to retain the car, he or she must continue to repay the debt. This is because bankruptcy only discharges the repayment obligation, it does not release the lender’s security interest in the automobile.

Here, the chapter of bankruptcy is again important, especially if the automobile has equity, i.e. its fair market value exceeds the remaining loan balance.

Under Arizona bankruptcy law, a chapter 7 bankruptcy filer may only protect up to $6,000 of equity in one automobile. This may seem low, but the federal bankruptcy exemption protects only $4,000.

A debtor who files chapter 13 may be able to protect additional non-exempt equity through the bankruptcy repayment plan.

If the automobile has negative equity or its market value is less than the remaining loan balance, the debtor may be able to redeem the automobile. Redemption enables the debtor to keep the automobile by paying its present fair market value instead of the entire loan balance.

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