When a borrower defaults on his mortgage, the bank does not foreclose on the home immediately. The foreclosure process can take months due to the legal proceedings the lender must initiate. Additionally, the lender usually does not start the process until the borrower has missed three or four payments. This gives the borrower plenty of time to make other arrangements. The borrower can also file for bankruptcy to attempt to keep their home. The type of bankruptcy protection the debtor files for determines whether or not they can stay in their home.
Chapter 7 is known as the liquidation chapter. The debtor’s assets are liquidated one by one. The proceeds from each sale are used to pay off creditors. When the debtor files for Chapter 7 bankruptcy protection, the bankruptcy court issues an automatic stay. This prohibits the creditors from continuing with the foreclosure process. The bad news is the stay does not cancel the foreclosure. Chapter 7 only repays all of the debts involved; it does not cancel the lien attached to the house.
The borrower signed two documents when he initially purchased his property: a promissory note and a security agreement. The promissory note is the borrower’s intention to repay the value of the loan plus interest. The security agreement pledged his house as collateral. When the borrower signed the security agreement, the lender gained the legal right to seize the borrower’s house if the borrower failed to fulfill the terms of the promissory note. Chapter 7 bankruptcy protection takes care of the promissory note, but it does not erase the security agreement. Under Chapter 7, the borrower may have to surrender his house regardless of the outcome.
The benefit of Chapter 7 is that it gives the borrower time to get organized. The bankruptcy proceedings typically take a few months, during which the borrower can save money and prepare to move. Once the bankruptcy has been concluded and their debts erased, the lender will move ahead with foreclosure. This could also take a few months, depending on where the lender was in terms of the foreclosure process when the automatic stay was issued.
The alternative to Chapter 7 is Chapter 13. The bankruptcy court issues an automatic stay under this chapter as well, halting the foreclosure process. Unlike Chapter 7, Chapter 13 is known as the reorganization chapter. Debtors enter into Chapter 13 to restructure instead of cancel their debts. The biggest advantage for borrowers who file for Chapter 13 bankruptcy protection is that they can keep their home.
Chapter 13 lets borrowers who have enough income pay off their overdue payments or arrearage. The borrower proposes a repayment plan up to five years in length to meet his arrearage and the remainder of the loan. The borrower must meet all of their repayment obligations until the mortgage is paid off completely. This is the only way the borrower can keep his home.
An interesting aspect of Chapter 13 bankruptcy protection is that second and third mortgages are cancelled. This happens only if the first mortgage is secured by the total value of the home. No equity is available to secure the other mortgages. So, the Chapter 13 bankruptcy court strips off the other mortgages and turns them unto unsecured debt. Under Chapter 13, unsecured debt is last in priority and often does not have to be paid off.
Bankruptcy and Foreclosure
Obviously Chapter 13 is preferable to Chapter 7. Unfortunately, Chapter 13 is only viable if the borrower has enough income. Even if the borrower loses their home, their debts are canceled and they are free to make a fresh start.