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How are debts and loans recovered by the lenders after a borrower passes away? A debt can be as small as 100 bucks for the credit card bill. It can be as big as millions of bucks for mortgage (or other fat) loans.

Are the relatives or heirs of the deceased person legally bound to repay all or part of those debts, irrespective of whether they were actively involved in those debts?

What legal channels can the lenders go through to recover their money?

I am assuming such laws may not differ vastly across the countries. But still it will help a great deal if you mention the country whose laws you are explaining in the answer.

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In Civil law jurisdictions, the heir of a deceased person will generally inherit all the possessions, rights and obligations - this may include debts.

So if a borrower passes away, the lender will typicall find out who is the heir, and ask them to pay. The heir will be required to pay, and the creditor can use the usual channels (reminders, collection agencies, court judgements) to make them pay.

However, if the inheritance is "under water" (has more debts than assets), there are ways to avoid having to pay the debts:

  • In most Civil law jurisdictions (e.g. Germany), acceptance of an inheritance is automatic, and a heir must file a document to refuse it (this is called disclaiming the inheritance). That means that a heir should quickly check if they inherited something, to be able to file the disclaimer in time.
  • In contrast, in the United States (which generally uses Common law), creditors are paid first, and the heirs only inherit what is left, in a process called probate. In that case, a heir need not explicitly disclaim an inheritance that is "under water" - they will simply not inherit anything. Note that the heir may choose to inherit certain debts in exchange for keeping certain assets - for example, if a home with a mortage is part of the inheritance, the heir may either choose to sell the home and pay the mortage, or keep the home and accept the mortage as debt.

Notes:

Even if inheritance is not automatic, the system usually allows a heir to disclaim it. There are other reasons for disclaiming an inheritance apart from debts, for example tax advantages, or the desire to grant the inheritance to a different relative.

If a heir disclaims the inheritance, no matter the reason, the inheritance automatically passes to the next heir in line. If all potential heirs disclaim in turn (as would typically happen if the inheritance has more debt than assets), the inheritance will usually fall to the state. Then, the assets will be divided up among the creditors (similar to insolvency proceedings). As an exception to the rule above, the state does not have to pay outstanding debts - so that money would be lost for the creditors.

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    Can you give some clarification as to which are included in "most jurisdictions", and add some references? For instance, as far as I know, this is not how it works in the United States. The decedent's estate (as managed by an executor or personal representative) is responsible for paying debts and then passing the remaining assets to the heir(s). If debts exceed assets, the heirs get nothing, but as far as I know they do not inherit the debts in any case, and they don't need to disclaim anything. – Nate Eldredge Sep 9 '16 at 11:49
  • @NateEldredge: Yes, the US system is different - I did not know that, thanks. I edited to include this. – sleske Sep 9 '16 at 13:04
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    I think when you say "most jurisdictions" you should change this to "most civil law jurisdictions" - common law countries are quite different. – Dale M Sep 12 '16 at 7:12
  • @DaleM: Yes, I learnt that from your answer. Thank you; edited. – sleske Sep 12 '16 at 7:14
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In common law jurisdictions, you generally cannot inherent a debt.

Details vary by jurisdiction, I will use NSW, Australia as an example:

Initial ownership on death

Liabilities

Any joint liabilities (loans, credit cards etc) automatically pass to the survivor(s).

Individual liabilities are "owned" by the estate

Personal Property

Any joint assets such as bank accounts, motor vehicles, caravans, furniture etc. automatically pass to the survivor(s). If any of these are security for a loan that lien passes with the property (the loan may or may not depending on if it was a joint loan); that means that if the loan is not paid out or renegotiated the lender can seize the encumbered property. Australia has a national register of personal property security and the lien must be registered to be enforceable.

Individually owned personal assets belong to the estate.

Real Property

Any properties owned as joint tenants (which is how spouses usually own property) automatically passes to the survivor(s). If the property is mortgaged, the lien remains.

Any real property owned individually or as tenants-in-common remains owned in the same proportions with the deceased's share being part of the deceased's estate. Australia has no inheritance tax or death duties but depending on the familial relationship of the deceased to the person(s) who ultimately inherit this share, the transfer may trigger a Capital Gains Tax event and leave the beneficiaries liable for this.

Contracts

Death generally terminates a contract so unless the terms of the contract actually deal with what happens on death, the parties future rights and obligations are at an end and they just need to settle up to the date of the death.

Distribution under a will

Executor

If the deceased left a valid will then it will name an executor (or more than one). The executor is required to take charge of the estate's assets and liabilities and distribute them to the beneficiaries in accordance with the will.

Probate

Depending on the nature of the assets, it may be necessary for the executor to apply to the Supreme Court for a grant of probate. This is basically an authority from the court that allows the executor to deal with the deceased's assets. For example, banks will usually require this before they will release funds.

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The executor must advertise the death and give any creditors or beneficiaries 30 days to come forward and make a claim. After six months, they may distribute the estate and any creditor or beneficiary who has not come forward will have no claim.

Managing the estate

The executor must settle the debts of the estate and perform any administrative tasks that need to be done, for example, lodging tax returns for the deceased (and the estate if it makes money). They are entitled to a fee for doing this, either the amount specified in the will or, if nothing is specified, a reasonable amount.

Distribution

Once all debts are settled, they can then distribute the remaining assets in accordance with the will. They are not required to liquidate them if the terms of the will can be satisfied without doing this. They can also seek the agreement of the beneficiaries on alternative means of fulfilling the will. For example, if a person's estate is to be divided between his two sons and it consists of a property worth $500k and $400k cash, an agreement for one brother to take the property and pay to the other (who gets the cash) $50k would give effect to the will.

If there are no assets, only liabilities remaining then there is nothing to distribute and the creditors have to write off their debts.

Intestate

If the deceased left no will, the procedure is essentially the same except the estate is administered by the Public Trustee. In this case, there are statutory rules that are followed about who the beneficiaries are and how much they get.

  • Good answer. Note that under Civil law systems, things work a bit differently - in particular, you can inherit debts if you are not careful. See my answer for details :-). – sleske Sep 12 '16 at 7:09
  • ‘Australia has a national register of personal property security and the lien must be registered to be enforceable‘ – this is incorrect. An unregistered (unperfected) security interest is generally enforceable, but a perfected security interest will take priority over it. See the PPSR overview. – sjy Oct 2 '18 at 9:55

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