The primary thrust of Chapter 7 Bankruptcy cases is to deal with consumer debts in such a manner as to ultimately “discharge” them – i.e. eliminate the obligation to pay certain types of debt and get a “financial fresh start”.
While not all debts are subject to “discharge”, many of them – primarily “consumer debts” – are. There are some circumstances where a debtor opts to continue to service certain debts that may be otherwise dischargeable in Chapter 7 bankruptcy proceedings. Being involved in a bankruptcy case does not prevent a debtor from voluntarily agreeing to pay a debt that would otherwise be dischargeable in the case.
When a debtor agrees to pay an otherwise dischargeable debt, the transaction is contractual. To have a binding contract in such an instance, the debtor and creditor enter into a “reaffirmation agreement” whereby the debtor “reaffirms” his/her intention and willingness to pay what is owed the creditor on the other side of the agreement.
Why Agree to Pay an Otherwise Dischargeable Debt?
The most common scenario where a debtor might choose to reaffirm an otherwise dischargeable debt is when a creditor holds a security interest on the property of the debtor. The property may be an automobile, a major appliance or other substantive commodity, or a mortgage on real property. A common thread with such property is “…a purchase over time with periodic or recurring payments”.
A creditor’s security interest protects the creditor if the debtor possessing the collateral is unable to pay the debt. In most cases, at some point the creditor usually has the right to take away and sell the property if contractual payments are not made. Bankruptcy does not erase or wipe out a valid security interest.
If a debtor in bankruptcy wants (or needs) to keep property subject to another’s security interest, he/she will likely agree to executing a reaffirmation agreement that pertains to that asset. Such an agreement obligates the debtor anew to terms of payment and repayment agreeable to the creditor. Like any contract, reaffirmation agreements must meet the six basic requirements for a valid agreement: offer, acceptance, party competence, lawful subject matter, mutuality of obligation, and consideration.
Another reason a debtor might agree to a reaffirmation agreement is when a security interest has more than one obligor, such as the case where a debtor in bankruptcy has an automobile on which there is a co-signor or guarantor. In Chapter 7 bankruptcy, a “discharge” is something that is available solely to the debtor; the discharge of obligations does not have any effect on the obligations of others. In most instances, a co-signor is liable to continue to make payments (or suffer repossession) upon the default of the primary debtor. With a reaffirmation agreement, the debtor is lifting the onus off the co-signor/guarantor.
Advantages and Disadvantages of Reaffirmation Agreements
Reaffirmation is anti-ethical to one of the primary purposes of bankruptcy, which is to give the debtor a clean financial position or re-start. At the same time, reaffirmation can be very useful to debtors who really need to retain passion of an item – as in the example above – an automobile perhaps.
Two advantages of reaffirmation are:
- Allows debtor to retain possession
- Avoids necessity of coming up with funds to redeem full ownership
On the other hand, some disadvantages of reaffirmation are:
- Leaves the debtor “stuck” with the debt (and potentially liable for fees
and costs over and above the amount of the debt)
- Potential for repossession of the security
- Only “one shot” at discharge when bankruptcy filed (reaffirmation fore-
closes future discharge of debt in bankruptcy for at least 8 years)
The decision to reaffirm is a serious one. Bankruptcy professionals recommend reaffirmation of an otherwise dischargeable debt only if:
- A debtor really can’t afford, for whatever reason, to live without the property
- A debtor can’t afford to redeem the property outright
- And – the creditor will agree to accept the current value of the property as
payment-in-full on the property (even when the debtor owes more on the
property when initiating bankruptcy **)
** Generally, Creditors know that if a debtor does not reaffirm they will have to
repossess, store, and sell the property; creditors also know that such costs may
be even more than the current value of the item; it makes sense for many creditors
to agree to reaffirmation
When assessing advantages of reaffirmation, a debtor should consider:
Need vs. Want: “Wanting” something is much different than “needing” something essential like an automobile needed for work or a livelihood. A “wanted” item is not a good reason for reaffirmation; a “needed” item may certainly well be.
Item Replaceable for Less Money: With dischargeable debt on an item such as an automobile, a cheaper, more affordable replacement may be a reason for going forward with discharge vs. reaffirming a debt that, in the end, may be at a significantly greater cost.
What can the debtor really afford: Reaffirmation Agreements carry personal liability for the reaffirming debtor. If the debtor defaults after agreeing to reaffirmation, a car with a loan of $20,000 may only be worth in a repossession significantly less, say $10,000. With personal liability, the debtor in the above-noted scenario might be liable for the additional $10,000. In this instance, the debtor should avoid reaffirmation, discharge the debt in bankruptcy, and buy a less expensive, more affordable replacement auto.
New “Deal” from Creditor: For the debtor considering reaffirmation, “affordability” is the key. If even under a “better deal” offered by a creditor a debtor cannot afford to make periodic, regular payments, reaffirming a debt by agreement is not advisable.
Real Property & Mortgages: Personal property (automobile, appliance, etc.) is treated differently than real property subject to a mortgage. When payments on either are current, the bankruptcy code makes clear that a debtor who has placed personal property in bankruptcy must reaffirm if he/she wishes to retain it (even if the account is current and not delinquent). With respect to property subject to a mortgage, a debtor current and not delinquent can retain the property without reaffirming with the original loan in place (“riding a debt through bankruptcy”, aka “riding through”).
No Delinquency at Reaffirmation: A debtor considering reaffirmation should be up-to-date on obligations (or make sure that he/she is able to catch up/become current prior to reaffirmation).
Position of Co-Obligor/Guarantor Is the debtor a “borrower”? or a “guarantor”? If the former, the advantages of reaffirming are two-fold – one, it allows the debtor to keep the property; two, it protects the co-obligor or guarantor from having to pay. If the debtor is a “guarantor” and the co-obligor is the “borrower”, it’s a different situation because a discharge would not necessarily mean repossession. It would reduce the creditor’s “security” for obtaining repayment if the borrower should default. If a debtor does not care if property is repossessed from the borrower, no reaffirmation should be agreed to by the debtor.
Repossession Considerations: If a creditor has the right under an agreement to repossess the property subject to the agreement (a “secured debt”), then an agreement reaffirms a creditor’s right to repossess upon default. Here, again, a “want vs. need” assessment is in order).
Improving Credit Rating: A debtor should not enter into a reaffirmation agreement solely for improving a credit rating.
Effects of Agreeing to Reaffirmation and Timing:
A debtor who enters into a reaffirmation agreement is obligated to pay the reaffirmed debt, with such debt being treated as if the debtor had never filed for bankruptcy. The process of reaffirmation of debt can have serious financial consequences.
Staying with the auto purchase example, a debtor who has signed a reaffirmation agreement concerning the car loan can face a repossession or be sued in court for the loan’s balance for a failure to make payments on the reaffirmed debt. What’s more, if a debtor cannot pay the reaffirmed debt, he/she must wait eight years after filing for bankruptcy before filing again to discharge the reaffirmed debt.
Understanding the terms of the reaffirmation agreement is paramount. A debtor should know and understand the total amount owing on the reaffirmed debt; the timing of the payments on the debt; and, the rights of the creditor to repossess or take away the property in case of default.
A reaffirmation agreement can only be entered during pendency of bankruptcy proceedings and before the granting of a discharge. Reaffirmation Agreements are filed with the Clerk of the Bankruptcy Court. Filing requirements are strict.
An executed reaffirmation agreement may be filed by any party to the bankruptcy proceedings, including the debtor or a creditor (with standing in the matter). The agreement must be filed within sixty (60) days after the first date set for the first meeting of creditors (unless the deadline is extended by the Court). Parties and creditors receive written notice of the first meeting of creditors.
A debtor does not have to be represented by an attorney to be eligible to file an executed reaffirmation agreement. If represented, however, the debtor’s attorney must certify in writing that the client has been advised of the legal effects and consequences of entering into a reaffirmation agreement (including the effects of a default under the agreement). The process is slightly different if the debtor is not represented by an attorney (debtor appearing Pro Se).
The Pro Se debtor will receive notice of a hearing upon or shortly after filing the reaffirmation agreement with the Court. At the hearing, the debtor explains to the court his/her reasons for wanting to enter into an agreement and how he/she can afford to make payments on the reaffirmed debt. Except for certain circumstances relating to reaffirmation of real property debt, the Bankruptcy Judge must approve the reaffirmation agreement with findings that it is in the debtor’s best interest and will not impose an “undue hardship” on the debtor or his/her dependents.
It is possible for a debtor to cancel an executed reaffirmation agreement. An agreement can be cancelled by the debtor by the later of: 1) the issuance of a discharge in the bankruptcy proceedings, or, 2) 60 days from the date the reaffirmation agreement is filed with the bankruptcy court.
Denial of Reaffirmation:
When a debtor lists his/her debts in bankruptcy it is with the expectation that those will be erased upon obtaining a bankruptcy discharge. That is a major advantage for debtors going through Chapter 7 bankruptcy. Reaffirmation of a listed debt (or debts) means that the debtor plans to pay those off. However, a debtor who can’t pay a reaffirmed debt runs the risk of being sued and having wages garnished or assets attached. In some instances, a denial of reaffirmation may be in the best interest of a debtor.
An example of denial being in the best interest of a debtor is where an automobile has a trade-in or other value of say $10,000 but the outstanding debt is much higher, say $20,000. While the value is $10,000, the debtor still rightfully owes the $20,000 balance. In such a case, it would not make sense for the debtor to reaffirm – and – it is a likely scenario where the Court would deny reaffirmation (and where an attorney would strongly advise against it).
Likewise where a debtor’s income is insufficient to pay monthly bills after going through a bankruptcy. A court is unlikely to allow reaffirmation of some debts where it is clear beforehand that a debtor will not be able to make periodic, regular payments against the debt. A bankruptcy court is unlikely to reaffirm debts where there is clear evidence of a likely future default with negative consequences for the debtor and/or his/her dependents.
In both instances noted above, a court will likely act to deny reaffirmations in order to prevent future financial difficulties for a debtor. In the same vein, a debtor’s attorney is duty-bound to advise against a reaffirmation agreement that may be harmful to the interests of a client.
The introduction of means testing as part of the 2005 bankruptcy reform made it more difficult for debtors to reaffirm loans or other debts. Under means testing standards, a debtor must certify that entering into a reaffirmation agreement will not create a hardship for a debtor or his/her dependents. In post-2005 Chapter 7 proceedings, qualifying to file is an indication that a debtor passed the means test and a median-income test (or, allowable expenses lowered a debtor’s income enough to qualify). That means that adding additional debt after close of bankruptcy may be, a priori, a “hardship”. If so, that is enough reason for the Court to deny reaffirmation of debts that could contribute to such hardship.
Reaffirmation of a Mortgage:
A mortgage on real property is a secured debt. The “security” is the property covered by the loan. Filing for bankruptcy does not change the nature of the mortgage obligation if the debtor wants to remain in the property. There are both pros and cons of reaffirming a mortgage in Chapter 7 bankruptcy proceedings.
In a Chapter 7 bankruptcy, the debtor is required to list all debts and assets, including real property. The court issues a stay, banning any collection activity or lawsuits by a debtor’s creditors, and then assigns a trustee to liquidate the debtor’s assets to pay any secured debts. A mortgage is a debt secured by the covered property.
Unsecured debts are discharged at the end of the process, which results in a financial “clean slate”, as noted earlier, for the debtor in bankruptcy. The laws of the states govern which property is exempt from seizure by the trustee. In all 50 states a personal, primary residence is exempt and safe from foreclosure.
Safe from foreclosure, that is, until the bankruptcy discharge.
Like any other reaffirmation agreement approved in bankruptcy, such an agreement with a home mortgage company means that the debtor agrees to continue making payments on schedule and on time while continuing to occupy the residence. Since the lender has a security interest in the home, a default after bankruptcy means that a debtor risks foreclosure with or without a reaffirmed mortgage. One “pro” of continuing to make payments is that the lender reports favorably to the 3 major credit reporting agencies – a sure way to improve a credit score after leaving bankruptcy.
On the down side, however, is the risk of being a debtor with shaky finances in the first place and then defaulting on a loan (reaffirmed or not). Non-payment on a residential mortgage is likely to lead to foreclosure and loss of a residence. Under the same scenario with a reaffirmation agreement that is enforceable, the debtor may lose the home AND continue to be liable for some or all a remaining balance depending upon the terms of the agreement.
Most analysts agree that reaffirming a mortgage is not generally advisable for a debtor exiting bankruptcy. At best, it would represent a “courtesy” to the mortgage lender in the form of additional “security”. In exchange, a lender with a reaffirmed mortgage is likely to continue to report favorably to credit agencies, but, other than that, there’s not much of an upside to a debtor.
Debtor’s should be careful and well-informed when considering whether to agree to reaffirm a secured debt in bankruptcy. Observers and analysts mostly agree that, in general, debtors should not reaffirm any debts in most instances. A debtor should not reaffirm any debt that they cannot afford to make regular, periodic payments on over the long-haul. Likewise, a debt should not be reaffirmed unless it covers something that a debtor absolutely cannot afford to live without (“needs” vs. “wants”).
A major, primary pitfall for a debtor opting to reaffirm a secured debt is that personal liability attaches with the making of the agreement. Using the automobile loan as an example, a debtor can go from a position of merely having the car repossessed after a default to the point of having to pay all the outstanding debt (beyond the “value” of the car) due to having personal liability resulting from an enforceable reaffirmation agreement.