COMMON CAUSES OF BANKRUPTCY
Prior to the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act in 2005, both houses of Congress solicited testimony regarding the rise in consumer bankruptcy filings. Consumer advocates, such as Harvard's Elizabeth Warren, pointed to rising medical costs as a common reason for filing. However, creditor advocates maintained that the majority of consumer bankruptcy filers were simply mismanaging their money, and were more than capable of repaying their debts. Our experience at Leiden & Leiden - derived from over 37 years of representing consumers in the CSRA - indicates that while mismanagement is one factor that leads to financial problems, it is clearly in the minority.
Essentially, there are four common causes of financial problems that lead to a bankruptcy filing for the typical consumer. However, these causes are not exclusive, and it is not uncommon for multiple factors to be present in any one case. And while the ultimate cause of a bankruptcy filing may be the initiation of a lawsuit, garnishment or foreclosure, at some point there was an event that triggered the inability to maintain those debts.
In recent years, the most common cause of bankruptcy has been employment-related. Cities in the CSRA such as Waynesboro, Eatonton, Thomson and Evans have seen the departure of jobs as manufacturing plants closed down. Unfortunately, other industries have not been quick to fill in the void left by those employers. Unemployment benefits are usually insufficient to meet the routine demands of the household, not to mention monthly debt payments. Even if new employment is obtained, the debts have already gone into default, and the monthly payments are higher than they were before. Unfortunately, there is a lot of competition for the available employment opportunities in almost every industry and profession, and the odds of obtaining a position with a comparable salary are very great.
Even individuals who have not lost their jobs can still suffer due to cutbacks and hour reduction, as employers struggle to maintain their bottom lines. The elimination of overtime or differential pay can yield a shortage of several hundreds of dollars for a worker. Even workers who customarily receive the normal 40 hours per week have seen their hours reduced to 32 or 30 hours per week, resulting in a 20-25% reduction in income. Locally, many government institutions, such as the Boards of Education and other municipal offices, have had to resort to imposing unpaid furlough days to stay within budget. Some employers may reduce or eliminate benefits, which does not reduce the workers' pay, but passes on costs for expenses like insurance.
The second most common cause of financial distress, leading to bankruptcy, is medically-related. Often a consumer will have a high amount of medical debt to an injury or medically-necessary procedure received at a time when they were uninsured or under-insured. However, this does mean that the debt to be eliminated is owed only to health care providers. Many times consumers will use credit cards and other financing alternatives to cover co-pays, deductibles, as well as prescriptions which may not be covered under their existing health care plans. This is especially common among senior citizens who receive fixed-income, but face escalating health care and prescription costs. Even the best insurance plans may still leave an overwhelming amount of debt to be handled by the consumer, especially if it involves a lengthy hospitalization or extensive period of rehabilitation.
The third most common cause of bankruptcy is due to domestic relations issues. Single mothers who do not receive child support - or receive it on an inconsistent basis - represent a high percentage of female bankruptcy filers. On the other hand, a divorced father who pays his child support on a timely basis may find that he is unable to maintain other bills. Many times both parties to a divorce struggle as they adapt to separate households (and expenses) without the benefit of the other spouses' income. At Leiden & Leiden, we often encounter situations where the responsible spouse discovers too late that the other spouse has saddled them with debt above and beyond their ability to repay. Even when a divorce Judge orders that one spouse should be responsible for payment of a debt, that order is not binding on the creditor, who can seek payment from either spouse.
The fourth cause of bankruptcy is usually overextension or mismanagement. However, this represents the lowest percentage of filers out of the common causes. Sometimes it may be a young professional who obtained credit cards to help with paying for college, but then became unable to make the payments when their student loans came due. In other times, a young couple may optimistically (an unadvisedly) purchase more house than they can afford. Many couples do not anticipate the financial expense of having and raising children, and fail to adjust their budgets accordingly. Sometimes the failure to budget at all, or monitor expenses, is the culprit.
At Leiden & Leiden, we are fairly certain that a prospective client will identify with some of these causes. We have helped people in those situations, and would welcome the opportunity to meet with you to discuss your possible bankruptcy options.
WHAT YOU SHOULD KNOW BEFORE YOU EVER COSIGN A LOAN
Our firm routinely meets with prospective clients who have encountered financial trouble after "cosigning" or "guaranteeing" a loan for a family member or friend that went into default. Many times they misunderstood the extent of their liability at the time that the loan was executed, or assumed that the lender would only pursue them for the debt after exhausting collection attempts from the primary borrower. It is important to know the reasons why a lender would require a cosigner, and the implications for the consumer who cosigns before agreeing to guarantee the debt.
WHY IS A COSIGNER NECESSARY?
Lending money is as much about evaluating risk as it is about obtaining a profit. If the lender believes that the borrower may be at a high risk of default - due to credit history, inconsistent employment, or other concerns - then it is going to take steps to reduce that risk. While charging a higher interest rate and demanding a larger downpayment may help to alleviate the risk of default (or reduce the amount of debt to be collected in the event of default), it still may not be enough for the lender to justify the loan. In many situations, the lender will insist upon the borrower to obtain a creditworthy cosigner before the loan will be granted. By requiring a cosigner, the lender now has two (or more) individuals who are equally responsible for payment of the debt. This reduces the risk of default, and makes the loan less risky. In addition, the cosigner will often have superior credit, which they will protect at all costs by making payments on the loan in the event that the primary borrower is unwilling or unable to do so. Ideally the primary borrower will make all scheduled payments in a timely basis, which will enhance their credit and reduce or eliminate the need for a cosigner in the future.
WHAT ARE MY OBLIGATIONS AS A COSIGNER OR GUARANTOR?
As a cosigner or guarantor (these terms are often used interchangeably), you are "guaranteeing" payment of the debt. This does not mean that you are simply vouching for the character of the borrower. Instead, you are saying that if the primary borrower does not make the payments, you will be responsible for the entire debt. While many consumers believe that there is some priority between being a primary borrower or "secondary signer," the law and the contract make no such distinction. The debt will be reflected on both credit reports, and any late payments or defaults will impact both credit scores. Unfortunately, many contracts lack any notice requirements for cosigners, meaning that they may not find out that the debt has gone into default until it is too late to correct the problem. I have talked to numerous parents and grandparents who have cosigned vehicles for children and grandchildren, and were not notified that there were any problems on the loan until the vehicle was repossessed and they were contacted about collection of the deficiency claim. Due not be misled by a lender or salesperson as to your legal liability when you cosign or guarantee a loan. A frequent complaint of prospective clients is that they felt "compelled" to cosign a car loan because their family member was already at the dealership with their vehicle selected, and that the only hang-up preventing completion of the transaction was their signature. This is a common pressure tactic at some dealerships, but the potential disappointment of a child or grandchild should not overcome common sense.
HOW CAN I PROTECT MYSELF IF I GUARANTEE A LOAN?
The best way to protect yourself is to never cosign a loan in the first place. As my father has told many clients, "bankers make their living by assessing risk and making loans. If a person who does that for a living doesn't think that your child can afford the loan, who am I to second-guess how they do their job." But if you disregard this advice and choose to cosign, there are some measures that can be taken to help protect yourself. First of all, make sure that the primary borrower does their homework. In the event of a car purchase for instance, make them secure financing before they ever set foot on the car lot. In this way, they (and you) will know the loan terms in advance of the purchase. This will also help to establish how much they can afford and what they can spend. It will also prevent a high pressure point of sale transaction, where financial common sense gives way to that must-have, "new car smell."
Secondly, obtain the financing through a bank or credit union that you already have a relationship with, and make sure that joint billing statements are sent out. This will allow you to monitor the payments by the borrower, so that you can make sure that the loan does not go into default. Local lenders are more likely to notify cosigners when there is a problem so that they can take steps to protect themselves. In the alternative, you can insist that the monthly statements come to you as the cosigner, and the primary borrower send the money to you. If the primary borrower feels that this is intrusive or demeaning, then you can allow them to seek other means of obtaining financing without your guarantee. In the event that the borrower is not local, you may have to monitor your credit report to verify compliance with the loan terms.
Finally, if it appears that loan may be headed for default, you may want to pay off or refinance the loan with a loan in your own name. This will prevent any dings on your credit score. You can then set up loan terms directly with the cosigner where they pay you directly, or sign the collateral over to you.
CONCLUSION
While this may seem like a condemnation of the "cosigning process," it is a more appropriately a tutorial on what can go wrong, and the significant risks involved. Cosigning a loan yields little tangible benefit to the cosigner or guarantor, yet at the same time imposes significant risk. Since the cosigner is usually the one with superior credit, and better resources, they will be the first collection target if something goes wrong and the loan defaults. Not only does this cause financial hardship, but it can often impair the personal relationships between the primary borrower and cosigner. As a potential cosigner, you have no reason not to assess these risks in the same manner that the prospective lender assessed the risks of default.
REBUILDING YOUR CREDIT AFTER A PERSONAL BANKRUPTCY
The importance of good credit in our economy cannot be understated. It is a factor to be considered not only in lending, but also in the acquisition of housing, employment and higher education. The effect of a personal bankruptcy on a consumer's credit is usually one of the primary concerns that we encounter in our daily practice, as we meet with financially-strapped consumers. This article will seek to address those concerns, and hopefully provide some guidelines on how credit can be re-established following a discharge in bankruptcy.
As a practical matter, the credit score of consumers who are in the process of filing for bankruptcy is usually pretty low already. The factors that motivate most bankruptcy filings - lawsuits, garnishments, foreclosures, and repossessions - will also significantly impair your credit. Many times the damage to one's credit has already been done long before they darken the door of a bankruptcy attorney's office. As a result, the eventual filing of a bankruptcy case will have negligible result on a consumer's overall credit score. However, the peace of mind (and peace and quiet) that comes with the elimination of the problematic effects will probably far outweigh any minor downward adjustment in an already low credit score.
In order to rebuild your credit after bankruptcy, it is important to understand that one of the primary factors that lenders consider in evaluating a loan/credit application is risk. Lenders want to predict the extent of risk of default or non-payment by the consumer, with a calculation of potential losses in the event of such a default. Surprisingly, a bankruptcy discharge will actually reduce the risk of non-collection for a variety of reasons:
1) There are restrictions on the amount of time that must pass between bankruptcy filings. Generally, a consumer cannot receive a bankruptcy discharge if they have received a discharge in a case filed within the previous 8 years. As a result, lenders do not have worry about the potential discharge of their debt in a subsequent bankruptcy.
2) Bankruptcy reduces the competition for the consumer's future earnings. The average number of creditors in a typical consumer bankruptcy is about 15. To a potential lender, that represents 15 other creditors with whom they will have to compete in order to get paid. More "competitors" translates into a higher risk of default. A consumer who emerges from bankruptcy has discharged those debts and eliminated the competition for a potential lender in the future.
3) Most legal proceedings such as lawsuits, garnishments or levies will have been eliminated during the bankruptcy, which will enhance the consumer's ability to make payments to a potential lender. Consumers who are subject to a lawsuit, judgment or garnishment will face the eventual seizure of a portion of their wages, or any funds held in deposit at a bank or credit union. Because this increases the risk of default - for instance if your bank account is frozen due to a judgment, all checks written on that account will bounce - it becomes more difficult to obtain financing, if it can be done at all. By virtue of a discharge in bankruptcy, these avenues of debt collection have been eliminated, alleviating another concern for a potential lender.
4) Most consumers who emerge from bankruptcy are much more knowledgeable about the cost of credit, and its importance. This knowledge is derived not only from the experience of having to file a bankruptcy, but also from the court-imposed counseling requirements that consumers must fulfill before - and after - a bankruptcy filing.
With this in mind, what are the best ways to rebuild your credit? Here are some suggestions:
1) Save money. This is probably the most important factor, even though it will not appear on your credit report or factor into your score. Open a savings account, and arrange for monthly deposit, even if it is as little as $10/month. I usually recommend a credit union account, as credit unions offer favorable terms to members, and their lending decisions are made locally. The more money you save, the more you will have available to make a down payment on a house or car loan. Remember that lenders are always evaluating risk. The more of your money that you put down, the less they are required to lend, which means that there risk is less. In addition, by contributing your own money, you are assuming more of the risk yourself.
2) Don't apply for credit/loans/financing unless necessary. Applying for a loan just to pay it off may not assist your credit, and lenders may potentially view it as a warning sign that a bankruptcy filing did not discourage any bad borrowing habits.
3) Maintain any debts that may have survived your bankruptcy. Many times certain debts may survive a bankruptcy filing, either by choice of the consumer - such as a mortgage loan on their residence or vehicle loan - or because the law would not allow it to be discharged, such as a student loan. Paying these debts on time, and eventually paying them off, will go a long way towards re-establishing your credit.
4) Avoid credit card debt. While credit cards have become a necessary evil in today's economy (try renting a car or booking a flight without one), the accumulation of credit card debt is another potential warning sign to potential lenders. Credit card companies aggressively solicit consumers who have emerged from bankruptcy for the reasons set forth above. Do not think that they are doing you a favor.
5) When applying for credit, always shop around. Don't feel the need to accept the terms being offered by an automobile dealership, or the bank that a realtor may have referred you to. Instead, always try to line up your financing in advance. Know what your repayment terms are going to be before you shop, and that way you will have a much better understanding of what you can afford. NEVER be afraid to walk away from closing on a loan, despite the pressure from the seller, if you do not feel that you can afford it.
6) Maintain stable employment, if possible. Lenders are repaid through earnings, and the more consistent those earnings are, the less risk of default.
