Bankruptcy & Mortgages

How to Prevent Foreclosure By Filing Bankruptcy

Whether a bankruptcy filing can stop foreclosure action on your home depends on several factors, including what type of bankruptcy you file (referred to as "chapters" in bankruptcy law), what you or your attorney ask for in your bankruptcy petition to the court, and the decisions made by the court and/or the bankruptcy trustee handling your case.

There are two basic types of bankruptcy available to consumers — Chapter 7 and Chapter 13. Both bankruptcy chapters create an "automatic stay" when filed, meaning that the debtor’s creditors must cease all collection activity until the bankruptcy case is either finalized or dismissed, unless the stay is lifted by the court.

Chapter 7 & Mortgages

A Chapter 7 bankruptcy, often called a "liquidation bankruptcy," completely discharges many unsecured debts if you qualify to file. Most consumers who do not have significant assets or income choose to file for protection under Chapter 7 bankruptcy.

Chapter 7 bankruptcy generally does not stop foreclosure action against consumers. The automatic stay ordered by the court when the case is filed would prevent a mortgage company from proceeding with foreclosure; however, since secured debts, such as mortgages, are not usually dischargeable in bankruptcy, the court or the trustee will usually grant relief from the stay to mortgage company to proceed with foreclosure if the homeowner’s mortgage remains delinquent.

One benefit that filing Chapter 7 can have for consumers is that the delay in foreclosure proceedings created by the automatic stay can allow additional time to bring mortgage notes current. You must keep the loan current; if you continue to miss your mortgage payments, the mortgage company is likely to proceed with foreclosure action against you.

Another possible benefit of Chapter 7 is that is that it can free up money every month that you were paying toward your unsecured debts, allowing you to bring your mortgage current and allowing you to make your payments on time in the future. So, Chapter 7 will not directly stop a foreclosure action against you, but it may delay the process and free up funds to help you prevent foreclosure.

Chapter 13 & Mortgages

Chapter 13 bankruptcy, also called a "wage-earners bankruptcy" is primarily designed for those debtors who own significant assets and have a regular income, but who cannot afford their monthly debt obligations. In a Chapter 13, the debtor makes payments to the bankruptcy court for a certain period, usually three to five years, until all of the petitioner’s debts are paid.

If the consumer cannot afford to repay all of his debts within the time period specified by his Chapter 13 plan, any debts remaining after all payments are made are usually discharged, meaning the debt is "forgiven."

Both bankruptcy chapters create an "automatic stay" when filed, meaning that the debtor’s creditors must cease all collection activity until the bankruptcy case is either finalized or dismissed, unless the stay is lifted by the court.

Chapter 13 bankruptcy has much more direct influence on mortgages and foreclosure actions than Chapter 7. As I mentioned, in a Chapter 13, the debtor proposes a repayment plan to the court, with the monthly payments based on his income. If the plan is approved, the court would distribute these payments to the creditors included in the Chapter 13 plan until the debts are paid off or until the plan period ends. A consumer can include the delinquent balance on his mortgage in a Chapter 13 plan; if the plan is accepted by the court, the mortgage would be brought current and the delinquent amount would be repaid over the course of the Chapter 13 plan.

Although a Chapter 13 could bring a mortgage current, you would be responsible for making all regular mortgage payments going forward in order to prevent the loan from becoming delinquent again; it is not unheard of for a consumer to lose his home to foreclosure after filing Chapter 13 because he was unable to make his regular mortgage payments on top of the Chapter 13 payments.

Chapter 13 is a good option for many consumers who have experienced a temporary financial hardship, causing them to fall behind on their mortgage, as it gives them time to repay the delinquency and avoid foreclosure. However, if you truly cannot afford your mortgage payments, you may want to strongly consider selling the home, as you could find yourself facing foreclosure again.

Foreclosure, Deficiency Balance, and Bankruptcy

When a home is foreclosed upon, the mortgage lender usually auctions the property at a foreclosure sale, applying whatever amount is received at the foreclosure sale to the debt owed on the mortgage. In many cases, the sale price at auction is not sufficient to cover the mortgage and other secured liens on the property, such as home equity loans; the difference between what you owe on the property and what the lenders actually receive is called a deficiency balance. In many states, deficiency balances can be collected like any other unsecured debt.

Some states prohibit creditors from collecting a deficiency balance with "antideficiency balance statutes." These laws state a lender may not obtain a judgment for a deficiency balance arising from a purchase money loan. This means an original mortgage lender cannot obtain a judgment for a deficiency balance if it forecloses. Antideficiency statutes vary significantly. Therefore, you should consult with an attorney in your state who has experience in property law to determine whether your state offers antideficiency laws and your rights under these laws according to your situation.

Whether a deficiency is created on a loan will depend on the balance of the loan compared to the value of the home. For example, if a home is worth more than the total amount of your loans, the loan may be covered by the auction sale price.

Many homeowners facing foreclosure choose to file for bankruptcy protection, either to try to stop the foreclosure proceedings, or to discharge any debt, including a deficiency balance, resulting from the foreclosure.

Bankruptcy and Lien Stripping

In some jurisdictions, bankruptcy can remove the liability of a second mortgage. If you live in the Ninth Circuit — Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon and Washington — and the balance of the first mortgage equals or exceeds the property’s market value, the bankruptcy trustee can strip the lien on the second. If you live in another circuit, the rule I just mentioned may not apply, depending on if and how your federal circuit court decided this question. A local lawyer experienced in bankruptcy will give you precise advice based on your circuit court’s decisions.

Mortgage, Note & Bankruptcy

When filing a Chapter 7, the debtor must file a statement of intention regarding the property. There are two options: Retain or Surrender. If the debtor selects surrender he or she must quit the property. If the debtor selects retain, then he or she must continue to pay the mortgage payments. If the debtor fails to do so, the mortgage creditor can foreclose. The mortgage creditor will ask the debtor to enter a reaffirmation agreement. However, there is no statutory requirement that the debtor execute (i.e., sign) the agreement. By not signing the agreement, the debtor has a strong argument that he or she no longer has personal liability for the loan. The creditor still has a lien against the property, but no claim against the debtor personally.

There is a cost to this freedom, however. Because the debtor has no personal liability for the mortgage, the debtor’s credit report will not reflect the regular payments on the mortgage. Each person needs to weigh the risk and reward of reaffirming a mortgage.

You may wonder why a bankrupt borrower has no personal liability for the home loan, but the lender has the right to foreclose on the property if the bankrupt borrower fails to make his or her mortgage payments.

A mortgage consists of two documents: a note (or bond); and the mortgage itself.

The note is the buyer’s personal promise to make the repayments. If there is a foreclosure against the property and the foreclosure sale does not yield enough to cover the outstanding mortgage debt, the note serves as the basis for a deficiency judgment against the borrower for the balance still due. A Chapter 7 bankruptcy strips personal liability from the note if the homeowner includes the property loan(s) in the bankruptcy filing and the bankruptcy trustee discharges the loan(s).

The mortgage itself is a document that gives the lender the right to have the property sold to repay the loan if the borrower defaults. Since the mortgage gives the mortgagee (the lender) an interest in the land, the mortgage is recorded at the county clerk’s office. A bankruptcy does not touch the creditor’s right to foreclose.

Reaffirmation & Mortgage

The only advantage to reaffirming a mortgage is the payment history may be reported to the consumer credit reporting agencies — Equifax, Experian, and TransUnion — which may result in a boost to the consumer’s credit score. However, if the consumer otherwise practices good credit hygiene and pays credit card bills on time and have a low credit utilization ratio, the mortgage will have only a slight effect on a consumer’s credit score.

Reaffirming the mortgage will not change the homeowner’s existing rights to his or her property. Put another way, a bankruptcy did not change the homeowner’s property rights. The homeowner can still sell, lease, or gift the property. Reaffirming the mortgage will not give a homeowner rights he or she do not already have.

Consult with your bankruptcy lawyer before you reaffirm a mortgage to understand your rights. Reaffirming your mortgage may result in your mortgage payments being reported to the credit reporting agencies, but doing so will reestablish your personal liability for the loan. I do not see the benefit (a chance at a slightly higher credit score) outweighing the costs (restoring personal liability for the note).