Straw loans are what happens when someone purchases a product (such as a vehicle) or otherwise incurs debt for the benefit of someone else. This is pretty common among family members. Someone with bad credit or no credit may rely on a friend or relative to get the vehicle or loan on their behalf, and make payments to the lender.
There are a few issues with straw loans – and some that are specifically problematic in bankruptcy, so let’s discuss some of these.
Problem #1 – The Loan Might Be Illegal
Notwithstanding state laws designed to curtail fraud, individual contracts may prohibit the incursion of a straw loan. Many mortgages and auto loans are granted with the condition that the borrower be the homeowner or primary driver. If the home or vehicle is purchased for someone else’s use, that could violate the terms of the contract.
Problem #2 – The Person Whom the Loan Benefits Isn’t Improving Their Credit by Payments Made on a Straw Loan
Although the beneficiary of a straw loan gets the immediate benefit of the vehicle or cash borrowed, the payments they make on the loan is not doing anything to help out their credit, since they are not on the loan. In contrast to loans with cosigners, only the person who legally incurred the debt is being affected credit-wise. To the extent payments are being made, that will help their creditworthiness, but the actual incursion of the debt (plus – god forbid the loan go into default) will damage their creditworthiness.
Problem #3 – Insider Preference Issues in Bankruptcy
If you are the beneficiary of a straw loan (meaning someone bought a home or vehicle or something else for you), and you’re making payments on that loan, these payments are either insider preferences (if payments are made to the person who got the loan for you) or preferences benefiting an insider (if payments are made directly to the lender). Either way, the trustee in your bankruptcy case may be able to sue the insider (the person who got the loan for you) to recover that preference payment you’ve made to them or on their behalf. In essence, you are paying on someone else’s debt. Whether you reaped the benefit of the loan is immaterial – legally, on paper, it is not your debt. From the bankruptcy court’s perspective, you should be paying your own debts before you attempt to pay someone else’s debt.
As always – WORDS ON PAPER MATTER. The informal agreements that commonly exist between family members do not trump what appears in black-and-white on a credit agreement.
Problem #4 – Household Contribution Income
Let’s take problem #3 and switch the roles. Instead of it being the beneficiary of a straw loan filing for bankruptcy, let’s say it’s the person who got the straw loan who needs to file for bankruptcy. If that’s you, and your family member is paying you to pay a debt that is – ON PAPER – legally YOUR DEBT, then you are receiving what we refer to as “household contribution income”. For people who are near or above median, this can result in you having to pay more to unsecured creditors than you would otherwise be required to pay.