When a debtor files a Chapter 7 bankruptcy, a secured creditor will often (and usually) be willing to enter into a Reaffirmation Agreement (RA) with the debtor. Typical examples are home mortgages and vehicle loans. This is an agreement to pay the creditor even though the debtor filed a Chapter 7 bankruptcy and has the right to have the underlying debt subject to the Chapter 7 discharge.
As part of the initial filing, the debtor will sign a Statement of Intention (SOI) relative to such secured loans at the time they file the bankruptcy, or shortly thereafter, indicating their intention as to the secured collateral and the loan. The SOI basically gives the debtor three choices, to wit:
- Surrender the collateral and discharge the underlying obligation as part of the Chapter 7 discharge.
- Reaffirm the underlying obligation and retain the collateral by agreeing to pay for it in accordance with the original terms of the loan and security agreement. Note that creditors will rarely agree to deviate from the original terms of the loan agreement.
- Redeem the collateral by paying the creditor the value of the collateral without regard for the underlying obligation or how much is owed on the debt. Such a payment must be made in full shortly after the bankruptcy is filed, and the creditor is then required to release the lien.
Obviously, option #3 is rarely exercised since most debtors do not have that kind of cash readily available to make a lump sum payment unless the value of the collateral is very small. An example of this would be a car that has a value of, say, $2,000 but the loan and lien encumbering it is $5,000. If the debtor can come up with the $2,000, then the creditor must release the lien by surrendering the title to the vehicle. Redemption involves a process that has to be followed, and can involve a hearing before the bankruptcy judge.
Many debtors select option #2 initially to reaffirm the debt but change their minds later. A debtor may change his/her mind shortly after signing the SOI, later when the actual agreement is presented to them, or even after signing the agreement and the agreement is filed with the court if they do so within sixty (60) days after the agreement is filed.
Once the RA is filed with the court and the time to rescind passes, it becomes final and the debtor is now obligated to pay the debt just as if they had never filed for bankruptcy protection or as if they incurred the debt after the bankruptcy filing. It is not subject to the discharge granted the debtor in Chapter 7.
This means that deciding to sign the RA is a very serious one that can have catastrophic consequences and must only be done only after careful consideration. Two major considerations include: 1.The likelihood in the future that the debtor will have sufficient income or resources to pay the debt and, 2. The equity in the collateral. If the debt cannot
be paid and the collateral is foreclosed upon or repossessed, the debtor will be liable for any deficiency and the Chapter 7 discharge will not apply to that deficiency. The filing of the Chapter 7 might at that point seem fruitless since a huge liability could still exist after going through bankruptcy.
As an example, let’s say that a Chapter 7 debtor owns a home with a fair market value of
$400,000 and the home is encumbered by a $350,000 mortgage. At first blush, it might seem that there is sufficient equity to protect the debtor if something unexpected occurs and the bank forecloses on the mortgage. But this may well not be the case. At a foreclosure sale, the debtor might get lucky and have the bank bid in the total of the mortgage or have someone show up at the sale who bids high enough such that the result is that there is no deficiency. But too often that is not the case. More typically, the bid at a foreclosure sale is in the vicinity of 75% of the fair market value which in the example means the bid is at $300,000. After deducting for foreclosure costs, which are significant, the debtor, if they have signed the RA, will now owe well over $50,000 to the bank as a deficiency which is not subject to the Chapter 7 discharge.
This is why many debtors change their minds, if they have initially indicated on the SOI their intent to reaffirm, and decide not to execute the RA. Many just decide to keep paying the debt, and if they do so in a timely fashion, the creditors will typically treat it as “no harm, no foul” and let the debtor keep paying. This is because they would generally rather have the money than have to liquidate the collateral. It is also not clear that a state court judge would permit a foreclosure in that situation.
The effect of this approach is it turns the debt into what might be referred to as a “non- recourse” obligation. The underlying debt has been discharged by the Chapter 7 case, and the only recourse that the creditor has is against the collateral by repossessing or foreclosing if the debt is not paid. But, except in unusual circumstances, they can never seek another dime from the debtor directly because the underlying debt has been discharged. It puts the debtor into the position of being able to walk away from the collateral property anytime they feel it is their best interest to do so without any repercussion other than not having the collateral property anymore.
Many bankruptcy attorneys will not sign reaffirmation agreements at all. If the negative consequences which are possible actually take place, the attorney may be subject to a malpractice action by the debtor who essentially says, “Why did you let me do that?” For the debtor that insists on doing the RA despite being counseled otherwise, such attorneys will simply say that they will not sign it, and let the RA be submitted without the attorney’s signature. This gets submitted to the court where the judge decides whether to approve the RA and, after going through a complete explanation to the client of pretty much everything set forth in this writing, will generally approve the RA if the debtor still wants to do it. The reason for this process is simple: the debtor cannot sue the judge.
Another aspect to this is that the bank will likely never report this account to a credit bureau again and that is often true even if the debtor has signed the RA. This confounds many subject to this process but the fact is that no creditor ever has to report any account
to any credit bureau. The only rule in this regard is that if they do report, it must be accurate.
The lack of reporting to credit bureaus often creates a perceived problem when the debtor wants to sell or refinance. The selling side is not too bad; you just have to berate the creditor to provide a payoff. The refinance can be trickier, especially if seeking to refinance with the original creditor. Some agents seem to think that a RA had to be executed but this is just not true. The debtor can always demand a payoff quote and also demand a full accounting of the payments on the account. This latter can be taken to a potential third party refinancer as proof of timely payments in the absence of credit bureau reporting. If the original lien holder does the refinance, it actually benefits them because the new refinance documents arguably restore the loan to one similar to the one which was not reaffirmed and is probably not subject to the Chapter 7 discharge. But many lender agents do not realize this and take an approach which is counter-productive to all parties.
Some lenders will say that since the debtor did not reaffirm the debt initially with the original bankruptcy filing, the lender cannot refinance the loan and that the debtor has to go back and reopen the case to do the reaffirmation agreement.
But this is nonsense and reflects a complete lack of understanding of the bankruptcy process and reaffirmation. In order to do as such lenders suggest, the debtor must pay a filling fee to reopen the case. Then the debtor has to file a motion to revoke the discharge (because once a discharge is granted and exists RA’s cannot be entered into), then enter into the RA, file it with the court, and then ask the court to grant the discharge again.
Other than having a judge look at the debtor’s attorney like they have ten heads if they tried such a thing, such a process would not only be very expensive (up to a thousand dollars or more), but it is completely unnecessary for the reasons set forth herein.
The bottom line is that if the debtor wants to refinance but the current lender does not understand this process sufficiently to be willing to offer such a deal, other lenders exist that will enter into refinancing with the debtor paying off the current lien as part of the process.
It must also be understood that such refinancing will not be at optimum interest rates since the debtor’s credit report will reflect a Chapter 7 bankruptcy for ten (10) years from the date of the filing (seven years for a Chapter 13) and creditors will use this as an excuse to not give the applicant the best rates possible. But as more time passes, the rates get better, and there is no flat rule meaning that the debtor should “shop” for the best rates. Also, the debtor that is four to five years from filing the bankruptcy will typically get a better rate than the debtor that filed a year ago. And, as one would expect, other factors still come into play such as income and equity.
At the end of the day and simply put, for some debtors the risks of not reaffirming and simply paying the loan often far outweigh that of reaffirming and having a creditor take later collection action that will irreparably harm them.
Finally, every debtor in Chapter 7 should consult with his/her own attorney for specific advice involving his/her specific situation since the within is only meant to be generic and not relied on as specific legal advice in any particular case.
© Copyright, Leonard G. Deming, 2022