It may be that you'll have to give up your home no matter what. In that case, filing for Chapter 7 bankruptcy will at least stall the sale and give you two or three more months to work things out with your lender. It will also help you save up some money during the process and cancel debt secured by your home.
Saving money. During a Chapter 7 bankruptcy, you can live in your home for free during at least some of the months while your bankruptcy is pending--and perhaps several more after your case is closed. You can then use that money to help secure new shelter. (For more on this, see the blog post How Bankruptcy Can Be Used to Deal With Foreclosure.)
Canceling debt. Chapter 7 bankruptcy will also cancel all the debt that is secured by your home, including the mortgage, as well as any second mortgages and home equity loans.
Canceling tax liability for certain property loans. Thanks to a new law, you no longer face tax liability for losses your mortgage or home-improvement lender incurs as a result of your default, whether you file for bankruptcy or not. This new law applies to the 2007 through 2012 calendar years. (See Nolo's article Canceled Mortgage Debt: What Happens at Tax Time?)
However, the new tax law doesn't shield you from tax liability for losses the lender incurs after the foreclosure sale if:
- the loan is not a mortgage or was not used for home improvements (such as a home equity loan used to pay for a car or vacation), or
- the mortgage or home equity loan is secured by property other than your principal residence (for example, a vacation home or rental property).
This is where Chapter 7 bankruptcy helps. It will exempt you from tax liability on losses the lender incurs if you default on these other loans. For more information on Chapter 7 bankruptcy, see the Chapter 7 Bankruptcy area of Nolo's website.
Chapter 7 Cannot Cancel the Foreclosure
With all this debt being cancelled, you may be wondering why the foreclosure on your home won't be cancelled too. The trouble is, when you bought your home you probably signed two documents (at least)--a promissory note to repay the mortgage loan and a security agreement that could be recorded as a lien to enforce performance on the promissory note.
Chapter 7 bankruptcy gets rid of your personal liability under the promissory note, but it doesn't remove the lien. That's the way Chapter 7 works. It gets rid of debt but not liens--you'll still probably have to give up the house under the lien since that's what provided collateral for the loan.
Chapter 7 Bankruptcy May Not Be Right For You
Not everyone can or should use Chapter 7 bankruptcy. Here's why:
You could lose property you want to keep. Chapter 7 might cause you to lose property you don't want to give up. As an example, if your wedding ring is particularly valuable, it may exceed the dollar amount of jewelry you're allowed to keep in a bankruptcy (under something called the "jewelry exemption"). In that case, the bankruptcy trustee could order you to turn the ring over to be sold for the benefit of your creditors. For more on what property you can and can't keep in Chapter 7 bankruptcy, see Nolo's article When Chapter 7 Bankruptcy Isn't the Right Choice.
You may not be eligible. Even if Chapter 7 bankruptcy would work for you, you may not be eligible. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, you are not eligible if your average gross income for the six-month period preceding the bankruptcy filing exceeds the state median income for the same size household. Nor are you eligible if your current income provides enough excess over your living expenses to fund a reasonable Chapter 13 repayment plan. For more information about how the new income eligibility test (the "means test") works, see Nolo's article Chapter 7 Bankruptcy -- Who Can't File?
Bankruptcy's Effect on Your Credit Score
Both bankruptcy and foreclosure will damage your credit score. However, sometimes bankruptcy is the preferable option when trying to rebuild credit. Here's why:
A foreclosure will damage your credit score for many years, will not get rid of your other debt, and is particularly harmful if you are house shopping.
In contrast, discharging your debts in bankruptcy will harm your credit score, but can help you rebuild your score quicker than after a foreclosure. This is because bankruptcy will leave you solvent and debt-free--and therefore able to start rebuilding good credit sooner.
Keep in mind that the current mortgage meltdown and credit crunch (which are prevalent at the time this article is being written) may change the way bankruptcy and foreclosure affect credit ratings.
If All Else Fails: Relief From Debt and Tax Liability
If you're certain you won't be able to propose a Chapter 13 repayment plan that a bankruptcy judge will approve, and Chapter 7 will provide only a temporary delay from the foreclosure sale, then what's the point of either?
If you have to lose your home--a bitter result to be sure, but sometimes unavoidable--you can at least view bankruptcy as the best way to get out from under your mortgage debt and tax liability. Bankruptcy also offers a way to save some money, which will help you find new shelter and weather the psychological and economic shocks that lie ahead.
To learn more about Chapter 13 bankruptcy and how it can help you avoid foreclosure, get Chapter 13 Bankruptcy: Keep Your Property & Repay Your Debts Over Time, by Robin Leonard and Stephen R. Elias (Nolo).
For information on Chapter 7 bankruptcy, including forms and instructions for filing yourself, get How to File for Chapter 7 Bankruptcy, by Stephen R. Elias, Albin Renauer, and Robin Leonard (Nolo).
If you're having trouble making your mortgage payments or already in jeopardy of foreclosure, see Nolo's Bankruptcy, Debt & Foreclosure Blog or the bestselling Foreclosure Survival Guide, now available online at no charge. Both are written by Stephen R. Elias, president of the National Bankruptcy Law Project.
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