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Car loans, leases and debt reaffirmation

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Dear Bankruptcy Adviser,
I filed bankruptcy two years ago and was leasing a vehicle at the time. I wanted to keep the vehicle and have continued to keep my payments current. Currently I have an opportunity to purchase a vehicle with half the car payment of my lease. Am I able to turn the lease in without any penalties from them? Or do I need to keep the vehicle for the year and a half until the end of the lease term?
— Rhonda

Dear Sender,
This is a great question because a lot of people find themselves in similar positions. You can absolutely surrender the vehicle to the finance company. I advise you and anyone else in your situation to dump the lease and buy the car.

Here’s how it works: Sometimes you file Chapter 7 and not all your debt is wiped clean. With some of your debt you can keep the item you bought (car, computer, home furniture, etc.) and agree to continue making payments after your bankruptcy. It’s called “reaffirming,” and what it means is that you make a promise to pay back what you owe AFTER your bankruptcy is discharged.

Technically, when you first signed the lease or purchase agreement, you were “affirming” that you will pay. But then, just like the T-shirt said, life happened (and you filed bankruptcy). Still, you wanted to keep driving the car, so you promised to pay even after the rest of your debts have been erased — thus, RE-affirming.

If you did not reaffirm the car lease because the finance company did not send you a reaffirmation agreement, then you can easily turn in the car and wipe out your obligation to pay. However, once you reaffirm the debt on the car you cannot stop paying. If you do, the finance company can sue you for the balance.

Now, this is the important distinction of your case: You have a leasing agreement, i.e., you wanted to keep using your car. Many others in your position have a buying agreement and want to maintain the fair market value in the car that they already own. This might seem like small potatoes, but it’s really a big deal.

Suppose you’re leasing a car. You file bankruptcy and reaffirm the leasing agreement. Once you’re out of bankruptcy, your payments will probably go back to what they were before — based on the original lease terms.

Now, suppose you finance the purchase of a car worth $15,000, file bankruptcy and want to keep the vehicle. The new laws that went into affect in October 2005 changed your options. If you have owned the car for less than 2½ years, then you will be obligated to pay back the entire outstanding balance before you can keep the car. However, if you have been paying on the car loan for 2½ years, then during the bankruptcy process you might be able to “redeem” the value of the car. You see, your car has technically decreased in value (depreciated) over the time you’ve owned it. Let’s say that you’ve owned the car for four years and that it has depreciated by $1,000 per year. Now the fair market value is $11,000. To “redeem” your car means to refinance your loan at the fair market value, thus wiping $4,000 of debt away and giving you a lower monthly car payment. I had one client take out a redemption loan (a loan designed for precisely this circumstance) and eliminate $8,000 of debt!

Why can’t you do this when you lease? Because you don’t own the car. The finance company does, and they’re not going to give you a break.

This illustrates a crucial principle of living in a capitalist society, Rhonda, and I make this point with all my clients: with rare exception, it is better to own than to rent. In the case of cars, I’m a fan of David Bach’s principle of buying only reliable used cars. They simply offer the most value for the dollar. And that’s affirmative.

Justin Harelik is a practicing attorney based in Los Angeles. To ask a question of the Bankruptcy Adviser go to the “Ask the Experts” page, and select “bankruptcy” as the topic.