Decisions About Your Home and Mortgages in Bankruptcy

Bankruptcy can be used to delay foreclosure proceedings, or to stop the foreclosure process all together. In Chapter 7, bankruptcy generally just stops foreclosure for a few months - but for some people, that delay is all that they need in order to be able to reorganize their finances: shed their unsecured debts and reinstate their mortgage. In Chapter 13, provided that you can meet the terms of your Chapter 13 repayment plan, bankruptcy will stop foreclosure for good and you will be able to keep your home. In general, Chapter 13 is a better option for people who want to keep their home - but there are situations where people can use Chapter 7 to keep their home, too.

We’ll explain how they both work below, but first we’ll give a bit of background about how mortgages work:

How mortgages and liens work

It’s important to understand how mortgages work, and what the two principal parts of a mortgage are, in order to understand how mortgages are dealt with in bankruptcy.

Mortgages are secured loans: the home is the collateral that forms the lender’s security interest in the loan. If the borrower does not meet the terms of the loan, by making their agreed-upon payments on time, the lender can seize that collateral. In the case of a home mortgage, this is called foreclosure.

A mortgage document contains two important parts:

  • The promissory note is the borrower’s promise to pay - your personal liability for the debt.
  • The lien is the lender’s legal claim on the security interest or collateral which, in the case of a mortgage, is the home. It is the lender’s right to seize the property in the case that the repayment terms are not met.

Bankruptcy can wipe out your personal obligation to repay the debt - in other words, the promissory note. However, bankruptcy on its own does not usually wipe out the lien associated with the debt (there are some exceptions to this, as noted below).

Filing Chapter 7 to shed other debts so you can keep your home

If you are current on your mortgage payments, but have a high amount of other debts, and if you know that your financial situation will be changing and you will soon be having trouble making future mortgage payments, Chapter 7 bankruptcy has a good chance of allowing you to keep your home. Changed circumstances could be that your mortgage is about to reset to a new higher payment that you know you will not be able to afford, or that you have suffered a recent wage cut that makes your current payments unaffordable.

This strategy works by allowing you to shed your other debts so that it will be easier to afford your mortgage payments.

First you will need to figure out what your homestead exemption is in your state (and whether you have the option of using the federal exemptions). If the equity you have in your home is less than the applicable homestead exemption, you do not have to worry about the trustee selling your home. (But do make sure that you check this before you file, because if you have too much equity so that the trustee wants to sell your home, you probably will not be allowed to withdraw your filing).

Since you are current on your mortgage payments, your lender is not permitted to foreclose on you (and they have no reason to). Once the automatic stay is imposed, your other creditors may not pursue any collections actions against you. You have the option of having your promissory note extinguished through the bankruptcy. However, you also have the option of reaffirming your mortgage with your lender.

Filing Chapter 7 will extinguish your promissory note on your mortgage - but, as we have explained above, not the lien associated with the mortgage. If it is important to you to keep your home, you can choose to reaffirm your mortgage note with your lender. Once you get your discharge, in three to four months, you will no longer be liable for your other unsecured debts. This strategy works for keeping your home provided that, by shedding those other debts, you will now be able to afford your mortgage payments.

Filing Chapter 7 to stay in your home (“riding through”)

This strategy works in a manner similar to that above: you are current on your mortgage payments, so your lender has had no reason to initiate foreclosure, and you file Chapter 7. However, in this case you do not sign the new promissory note to reaffirm your mortgage.

What this means is that the debt owing on your mortgage, that promissory note, will be extinguished. Your lender’s lien on your property, though, cannot be extinguished through Chapter 7. However, as long as you remain current on your monthly payments, they cannot act to seize that collateral - your home. That’s right: you no longer owe the debt associated with your mortgage, but you must keep making your regular monthly payments to keep your lender from moving to seize your home.

This process is known as “riding through” the bankruptcy. The concept of “riding through” a bankruptcy is still one of the gray areas in the Bankruptcy Code, and exactly how bankruptcy law applies in specific situations is not completely clear; it will probably vary from state to state. However, the current understanding is that, as long as you remain current on your mortgage payments, you can continue to occupy and live in the home.

But remember: your lender still has a lien against the property. This means that you would not be able to sell the home, or even refinance it, without first settling that lien.

Filing Chapter 7 to catch up on arrears and keep your home

Even if you are behind on your mortgage payments, you may be able to use Chapter 7 to keep your home - especially if shedding your other debts would enable you to catch up on your arrears   and afford your monthly mortgage payments.

Even if your lender has already initiated foreclosure proceedings, the automatic stay imposed the moment that you file Chapter 7 puts an immediate halt to the foreclosure. This automatic stay may be in place for as little as one or two months, if your lender acts quickly to have it lifted, or it could be in place for the entire three to four months it takes for your bankruptcy case to be processed and for you to receive your discharge.

While that stay is in place, you have some breathing space as your creditors are forced to stop contacting you. You can stop making any payments towards the unsecured debts that will be discharged through the bankruptcy. If the money you can save in that period is enough that you are able to pay off your arrears and reinstate your mortgage, your lender will cease their foreclosure action. Once you receive your discharge, you will no longer be responsible for bill payments for any of the discharged debts, and you can focus on your mortgage payments. This strategy works for keeping your home provided that, by shedding those other debts, you can now afford to pay your mortgage.

Filing Chapter 7 to delay foreclosure

Unfortunately, for some people the numbers just do not work out that they will be able to keep their home when they declare bankruptcy. However, there still may be financial advantages - and even personal and emotional advantages - to filing Chapter 7 and taking advantage of how the automatic stay delays the foreclosure process.

If your lender has already initiated foreclosure, at very least, you will get a couple of months of relief from the automatic stay: your mortgage lender will have to halt the foreclosure process, and your other creditors are not permitted to contact you either. This gives you some time to gather your thoughts, look carefully at your financial situation, and come up with a plan.

If you cannot come up with a reasonable plan that allows for keeping the home using one of the strategies outlined above, the period that the automatic stay is in effect allows you to live in your home for free for several months (and probably for several months after that, too, as your lender re-initiates the foreclosure process). It gives you time to look into finding alternative accommodation. The money you save during this period can help you get started in your new home.

Filing Chapter 13 to keep your home

The automatic stay imposed by the court immediately stops the foreclosure process as soon as you file Chapter 13 bankruptcy. You must then work out a Chapter 13 repayment plan with your trustee and your lender that will bring you up to date on all missed payments by the end of the plan. This means that you reasonably must be able to afford to make those payments (which will consist of your regular monthly mortgage payments, plus a portion of arrears) each month - or your repayment plan will not be approved by the court.

For example, let’s say your regular mortgage payment is $2,000 per month. Let’s say that you are behind on your mortgage payments by four months, or $8,000, and that including other fees and penalties the total that you back-owe comes to $9,000. Over the five years of your repayment plan, that comes to $150 per month to catch up on arrears (the $9,000 you owe divided by 60 months). Therefore, to have your repayment plan approved, you would be have to be able to afford to pay $2,150 per month: your regular mortgage payment plus the top-up to catch you up on arrears.

Once your repayment plan is approved, your lender is bound by the terms of that plan. If you continue to make your regular payments for the term of your plan, you will avoid foreclosure and you will be able to keep your home.

If you are underwater on your home

If your home’s value has dropped since you purchased it, you may owe more on your mortgages than what the home is currently worth. This is known as being “underwater.” There are numerous points to consider if you are underwater on your mortgage.

About the homestead exemption

Being underwater on your home means that you have negative equity. You have no need of the homestead exemption since you have no equity, and your trustee will therefore not attempt to sell your home if you are filing Chapter 7. If you are filing in a state that allows you to use any leftover homestead exemption towards other assets (i.e. using it as a wildcard exemption) you should look into doing that.

Junior mortgages in Chapter 7

If you are filing Chapter 7, and have a second or even third mortgage, and your home’s value is less than the value of the first mortgage, then these junior mortgages are no longer secured. This means that you can stop making payments on those mortgages - temporarily, at least - because the bankruptcy will eliminate the debt associated with them. Note, though, that the bankruptcy will not extinguish the liens associated with those mortgages. You won’t have to worry about your junior lenders attempting to foreclose on you while your home’s value is still so low, as those lenders would not receive anything.

However, once your home’s value rises to above the value of the first mortgage, so there is equity associated with the junior mortgages, those junior lenders might choose to foreclose on you. And if you ever want to sell or refinance your home, you would first have to deal with those second and third liens.

Junior mortgages in Chapter 13

If you are filing Chapter 13, have a second or even third mortgage, and your home’s value is less than the value of the first mortgage, then these junior mortgages are no longer secured. The difference from Chapter 7 is that in Chapter 13 you can move to have those liens stripped. Since that junior mortgage is entirely unsecured, the loan becomes reclassified as unsecured debt - in the same category as credit card debt, medical bills, etc. In other words, not only can that debt now be discharged through bankruptcy, but after discharge the lender will be required to remove the lien from your home.

Read on for our next article in this series: Dealing with Vehicles and Other Financed Items in Bankruptcy