When you die with debt, what happens? Someone is going to have to sort out your finances, including any debt you may have. We tapped Phil Roemaat, an advanced planning attorney with Northwestern Mutual, to help demystify an often misunderstood scenario: What happens to debt when you die?
When you die, your bank accounts, real estate, businesses and other possessions are lumped together to create what's called an estate.
Then, your estate will go through a court proceeding known as probate. A court will help determine the value of the estate, and then make sure the estate is used to square away lingering debts before anything is divvyed up to designated heirs.
The death of the borrower may trigger a default, which means a co-signer may have to pay off the entire debt immediately.
MORTGAGE AND CAR LOANS
These debts protect the lender with a level of security. That’s because the debt is backed (or secured) with something of value. For instance, if you don’t pay your mortgage, the lender can foreclose on your home and sell it to repay the debt. Car loans are another good example.
When you die, these types of secured creditors typically get first dibs on the part of the estate that secures the debt. In other words, the bank that gave you the loan to buy your home would get the proceeds from the sale of the home to pay off the loan. Anything that’s left over would go to your estate and eventually your heirs.
CREDIT CARDS BALANCES
Credit card companies or others like them are next in line. (These are called “non-secured” debts.) Because this debt is unsecured, there isn’t anything that could be sold to pay the debt.
"For debts like credit card balances, for which there is no security attached, these folks can file a claim on your estate," says Roemaat. "When you die, whoever's managing the estate is required to send a notice to creditors to file a claim, which is later handled from the estate assets."
That means if there’s money in your estate (maybe the house sold for a lot more than was owed on the mortgage) the court will use that money to pay the debt. But if there’s no money left, the credit card company may not get what it’s owed.
Your federal student loan balances are actually wiped away when you die. That’s not the case for most private student loans. Things get even murkier if there's a cosigner, who'll end up inheriting the student debt. And the death of the borrower may trigger a default, which means the co-signer may have to pay off the entire loan immediately.
"With so many parents co-signing for their kids' college loans, we see more and more taking out life insurance policies for their children to cover these balances should they outlive their kids," says Roemaat. "If there's no co-signer, most private loan lenders can come after the deceased person's estate to resolve the debt."
Things can get tricky if you live in what's known as a community property state. That’s because in a community property state, your spouse owns one-half of everything you own, including your debt. There are nine states that fall under this umbrella (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin). If you live in one of them, your spouse may be on the hook for any debts you incurred during your marriage. Alaska allows you to choose whether you want your estate to be governed by community property or common law like the rest of the country (there are a number of estate planning reasons why you might choose one or the other).
"No matter what state you live in, you'll also assume a deceased spouse's debt if you have any joint debt or if you cosigned for any of their loans," adds Roemaat.
Now that you know what happens to debt when you die, you may want plan ahead to make sure you don’t leave a burden for someone else. A financial planner or professional and an estate planning attorney can help you make sure that your assets pass to your heirs as smoothly as possible.