Bankruptcy helps you get out of debt by breaking the contract between you and your creditors. Sometimes, however, you’d like to keep a loan in place—especially if you want to retain the property securing the debt, such as a car.
Reaffirmation is the process wherein you agree to remain responsible for a debt so that you can keep the property securing the debt (collateral). You and the lender enter into a new contract—usually on the same terms—and submit it to the bankruptcy court.
Before you can enter into a reaffirmation agreement, you’ll need to be current on the loan. Also, you must be able to protect all of the equity in the property with a bankruptcy exemption. If you can’t exempt all of the property’s equity, the trustee will likely sell the asset and use the proceeds to pay your unsecured creditors.
(For more information, see Secured Debts in Chapter 7 Bankruptcy: An Overview.)
When you reaffirm a debt, you agree that you will still owe the debt after your bankruptcy case ends. Both the creditor’s lien on the collateral (which gives the creditor the right to take the property if you fail to pay as agreed) and your liability for the debt under the original contract (called a promissory note) essentially survive bankruptcy intact. In most cases, it will be as if you never filed for bankruptcy for that debt.
Collateral and Secured Debt
It’s common to wonder how secured and unsecured debt are different. The answer is simpler than you might think.
When applying for a credit account or taking out a loan, the lender might ask you to put up collateral (valuable property) that it can sell if you fail to pay your bill—especially when borrowing a large sum of money. The collateral assures or guarantees the lender that it will get paid if you stop making your payment as agreed.
Securing a loan with collateral creates a “lien” on the property—a type of ownership interest that remains until the borrower pays off the debt. It’s the lien interest that gives a creditor the right to repossess your vehicle if you fail to make your payment. Likewise, if you fall behind on your mortgage, the lien will allow the lender to foreclose on your home.
A bank or creditor who owns a collateralized debt has what is called a “secured debt.” If the bank seeks reimbursement in a bankruptcy case, it will file a “secured claim.” If the bankruptcy trustee sells the property, the trustee must pay the secured lender first before distributing funds to unsecured creditors. (Learn more in the article What Is a Secured Claim in Bankruptcy?)
However, not all creditors require a borrower to provide security when making a loan or when providing a service on credit. An “unsecured” creditor doesn’t have a lien interest in collateral, so it cannot take and sell the borrower’s property to pay off the debt without doing more. Credit cards, medical bills, and personal loans (such as payday loans) are all examples of unsecured debt. An unsecured creditor can gain a security interest by winning a debt collection lawsuit and recording the money judgment with the local recorder’s office or the appropriate state agency.
Reaffirmation provides a sure way to keep collateral as long as you abide by the terms of the reaffirmation agreement and keep up your payments. As long as you stay current on the payment, the lender won’t be able to take back the property.
Reaffirmation also provides a setting in which you might be able to negotiate new terms to reduce your payments, your interest rate, or the total amount you will have to pay over time.
Because reaffirmation leaves you personally liable for the debt, you can’t walk away from the debt after bankruptcy. You’ll still be legally bound to pay the deficiency balance even if the property is damaged or destroyed. And because you have to wait eight years before filing another Chapter 7 bankruptcy case, you’ll be stuck with that debt for a long time.
For instance, if you reaffirm your car note and then default on your payments after bankruptcy, the creditor can (and probably will) repossess the car, auction it off, and bill you for the difference between what you owe and what the trustee received at auction.
Example 1. Suppose that you owe $25,000 on your car before you file for Chapter 7 bankruptcy, you most likely will continue to owe $25,000 on your car after you file for bankruptcy (unless you negotiate a lower amount in your reaffirmation agreement). If you can’t keep up your payments and the car is repossessed, you’ll owe the difference between the amount you reaffirm for and the amount the lender can sell the car for at auction (considerably less than you owe, in most cases). The amount remaining is called a “deficiency balance.” Nearly all states permit a creditor to sue for a deficiency balance for most types of property. About half of the states, however, don’t allow deficiency balances on repossessed personal property if the original purchase price was less than a few thousand dollars.
Example 2. Tasha owns a computer worth $900. She owes $1,500 on it. She reaffirms the debt for the full $1,500. Two months after bankruptcy, she spills a soft drink on it and the computer is ruined. Although she has lost the computer, because she reaffirmed the debt, she still has to pay the creditor $1,500.
The first step is ensuring that you can keep the property out of the bankruptcy trustee’s clutches. If the property has equity in it that you can’t protect with a bankruptcy exemption, the trustee will sell it, pay the lender, give you the exemption amount, and use the remaining proceeds to pay unsecured creditors.
(Find out how much equity you can protect in Bankruptcy Exemptions by State.)
If you can protect all of the property equity, then you can use a reaffirmation agreement to continue paying on property that’s encumbered by a lien. You and the creditor must agree to any change in terms.
Also, you or the lender must file the agreement in court as part of the bankruptcy case. If you’re not represented by an attorney, the bankruptcy court must review the agreement in a reaffirmation hearing. (If you have a lawyer, the lawyer must sign the agreement and attest that it will not cause you undue financial hardship.)
At the hearing, the judge will consider how the reaffirmation might affect your post-bankruptcy budget and whether you can afford the payments. The judge can disapprove the agreement if it is not in your best interest or would create an undue hardship for you or your family. Reaffirmation agreement rejections occur if it appears that you won’t be able to make the payments after paying your basic living expenses or if you owe much more on the debt than the property is worth.
Because reaffirming a debt comes with the disadvantage of leaving you in debt after your bankruptcy case ends, you should consider it only if:
Reaffirmation might be the only practical way to keep some types of property, such as automobiles or your home. Also, reaffirmation can be a sensible way to keep property that is worth significantly more than what you owe on it.
If you decide to reaffirm a debt, it’s usually worth the effort to try to get the creditor to accept less than you owe as full payment of the debt. By contrast, for most people, it’s not a good idea to reaffirm a debt for more than what it would cost you to replace the property.
If you need the collateral, make sure you keep up your payments before filing for bankruptcy so you can stay on the creditor’s good side. If you fall behind, the creditor has the right to demand that you make your account current before agreeing to a reaffirmation contract.