When you file for Chapter 7 bankruptcy, and you have a car loan, you must indicate in your bankruptcy paperwork whether you intend to keep the car or give it back. If you want to keep it, you’ll have to pay for it, and one of the ways you can do so is to enter into a new contract with the lender in a process known as reaffirming the car loan.

(To learn about other car options in bankruptcy, see Chapter 7 Bankruptcy and Your Car.)

Protecting Your Car Equity in Chapter 7 Bankruptcy

When you file for bankruptcy, you don’t give up everything that you own. You’re allowed to keep (exempt) property that you’ll need to maintain a job and household, such as clothing, household furnishings, and a modest car. In Chapter 7 bankruptcy, the bankruptcy trustee assigned to administer your case will sell any nonexempt property for the benefit of your creditors.

Therefore, the first step in determining whether you can keep a car is to decide whether or not you can protect all of the car equity. Each state has a set of bankruptcy exemptions that you can use to protect property from creditors. Some states allow you to choose between the state exemptions and the federal exemption scheme.

If you can protect all the car equity, you’ll have gotten over the first hurdle. But if you’re making payments on the car, there’s more to do.

You Must Pay the Car Loan to Keep the Car

When you take out a loan to buy a car, you give the lender a security interest—or a lien—in the vehicle. The lien allows the lender to take the vehicle to satisfy the debt if you stop paying on it.

Filing for Chapter 7 bankruptcy wipes out the contract that obligates you to pay the car lender, but the lien remains. So once the bankruptcy case is over and the automatic stay lifts (the order that prevents creditors from collecting debt), the lender will be able to repossess the car. Also, a lender that wants the car sooner can file a motion asking the court to lift the automatic stay while the case remains active.

Because of these rules, if you want to keep the car, you’ll need to make arrangements to continue paying for it.

What Is a Reaffirmation Agreement?

When you reaffirm a car loan in bankruptcy, you sign an agreement with the lender that you will continue to pay for the car as if you had not filed bankruptcy in exchange for keeping it. To reaffirm a car loan, you must be able to show the court that the vehicle is necessary and that the payment is reasonable. You must also be able to show that the car payment isn’t an undue hardship on your household (you’ll still be able to afford the necessities of life).

• Effect of a reaffirmation agreement. When you reaffirm a debt, you agree to be responsible for the debt as if you had not filed bankruptcy. Once you receive your discharge, you’re bound by the agreement unless you rescind it within 60 days of the signing (see below). You can keep your car as long as you keep making the payments. However, if you default on the payments, the lender can repossess it and sell it at auction, and you’ll be responsible for any remaining balance due under the loan agreement (called a deficiency balance), as well as auction fees.
• Canceling a reaffirmation agreement. If you sign a reaffirmation agreement and change your mind about keeping the car, you can rescind (cancel) the agreement. You must rescind within 60 days after you sign the agreement or before the court enters your discharge, whichever is later. If you rescind on time, you can give the car back without having to pay for it.

(Find out more about the steps you’ll need to take to keep your car, including the reaffirmation process, in Your Car in Chapter 7 Bankruptcy.)

Pros and Cons of Reaffirmation

The benefits of reaffirmation include:

• You secure your interest rate and payment. After a Chapter 7 bankruptcy, obtaining a car loan isn’t impossible, but your interest rates will be high, and you will likely only be able to obtain financing through a subprime lender. If you turn in your current car and need to finance a new one, you probably won't get terms as favorable as your old loan.
• You don't have to start over again with a new loan term. If you surrender your car in bankruptcy, you might have to buy another car on credit, which would mean more years of payments.
• You know what you're getting into. Reaffirming an existing loan means maintaining a relationship with the same lender and keeping the same loan terms.

Reaffirmation does have a significant drawback, however. If you reaffirm the loan and miss payments after your bankruptcy is over, you’ll be liable for the loan, including any deficiency balance remaining after the lender repossesses the car and sells it at auction. If you don't reaffirm the loan and surrender the vehicle, however, you won’t be liable for a deficiency balance—it will be wiped out in the bankruptcy. (Learn more about deficiency balances after car repossession.)

Example. Chloe reaffirmed the loan on her car in Chapter 7. Six months after her Chapter 7 discharge, Chloe defaulted on her payments. When the lender repossessed the car, Chloe owed $10,000. The lender sold the car at auction for $6,000 and incurred $300 in auction fees. Chloe is responsible for the $4,000 deficiency balance plus the auction fees.

In some jurisdictions, the lender will allow you to continue paying on the car without entering into a reaffirmation agreement. In this situation, you wouldn’t be responsible for a deficiency balance if you weren’t able to continue making payments. However, without a contract, the lender could repossess the car at any time, even if the loan was current.

You can find out the practices allowed in your court by consulting with a local bankruptcy lawyer.