You can use Chapter 7 bankruptcy to save your house if:
- you are current on your mortgage payments when you file (or you can get current in a hurry), and
- your equity in the house (if any) is adequately protected by the exemption laws available to you in your state.
If you are not (and can’t get) current on your payments, Chapter 7 bankruptcy will be only a temporary remedy. The lender will be able to proceed with a foreclosure within two or three months. You should instead explore Chapter 13 bankruptcy, which provides a way for you to keep your house by spreading out your missed payments over several years. (See our article on stopping foreclosure with Chapter 13 bankruptcy.)
Staying Current on Your Payments
Suppose you are current on your payments but expect to fall behind in the very near future for one reason or another. This might be the case if your mortgage interest rate is due to reset higher, you’ve reached the principal cap on an interest-only loan, or you have just lost some work hours or been laid off.
In these and similar situations, Chapter 7 bankruptcy may be a big help. Except for a few categories of debt, you can eliminate virtually all your unsecured debt in about three months. That’s right, all your credit card debt, personal loans, medical debts, money judgments, and car repossession deficiencies go away. Once your unsecured debt load is eliminated or greatly reduced, you will have a much better chance of paying your mortgage.
Once you file, you may not be able to change your mind. For example, if you file for Chapter 7 and then discover that you won’t be able to keep your house because it has too much equity, you probably won’t be allowed to back out and dismiss your bankruptcy case. This is because your right to dismiss is based on the best interests of your creditors, and if the creditors would receive a distribution from the sale of your house, their interests require the bankruptcy to go forward.
Protecting Your Equity
In every Chapter 7 case, the bankruptcy trustee is primarily interested in finding property belonging to the debtor that can be sold for the benefit of the creditors. Unless selling the property would produce money for the creditors, the trustee isn’t interested in it. The measure of value in property that might benefit creditors is called “equity,” and the primary purpose of exemptions is to protect this equity by requiring the trustee to pay you the amount of the exemption if the property is sold. Selling property that’s covered by an exemption would benefit you, not your creditors, so the trustee won’t sell it—and you’ll get to keep it free and clear.
All but two states (New Jersey and Pennsylvania) let you keep at least some home equity when you go through Chapter 7 bankruptcy. Protection for home equity varies dramatically from state to state; you get $500,000 in Massachusetts, $50,000 in New York, and just $5,000 in South Carolina. In 17 states, two exemption lists, one state and one federal, are available. You can pick the one that’s most advantageous to you. (Though if you haven’t resided for at least two years in the state where you file for bankruptcy, you must use the exemptions for the state where you resided before the beginning of that two-year period.)
If your equity is under the amount that’s protected, you should be able to keep your house when you go through Chapter 7 bankruptcy.
EXAMPLE: Stuart and Stephanie have built up $25,000 of equity in their house, and they’ve managed to stay current on the mortgage payments. But credit card and medical debts (their young son has been ill) have piled up alarmingly, and they’re considering bankruptcy.
They live in Maine, which lets them keep $70,000 of equity under the state’s homestead exemption. If they filed for bankruptcy, the trustee would not take their house and sell it. That’s because after paying off the mortgage, only $25,000 would be left—and that wouldn’t be available to creditors because it’s within Maine’s $70,000 homestead exemption, which means it would have to be paid to Stuart and Stephanie.
If you have a lot of unprotected equity, however, the bankruptcy trustee is going to want to get at it, so that it can go to your creditors.
EXAMPLE: Petra owns a house in New York, which she inherited from her grandfather. The house carries a mortgage of $300,000 but is valued at $500,000, meaning Petra has equity of $200,000. In New York state, you may protect only $50,000 worth of equity in your house. Petra is in a jam. She can’t borrow against her equity because she can’t afford to pay down another loan, but she needs the protection of bankruptcy against several creditors who are threatening to sue her. She’s managed to keep current on her mortgage payments, but she won’t be able to keep that up if her creditors sue her and garnish her wages.
If Petra filed for Chapter 7 bankruptcy, the bankruptcy trustee would sell her house, pay off the mortgage, give Petra her $50,000 exemption, and use the rest to pay Petra’s creditors. If there were anything left over after that, Petra would get that as well. If this is not the result Petra wants—and it probably isn’t—she should not file for Chapter 7 bankruptcy.
How much home equity can you keep? If you have home equity and you want to find out how much your state protects, or what other property is protected under your state’s exemption laws, go to http://www.legalconsumer.com/. Click "50 State Bankruptcy Exemption Laws" and scroll down to find your state in the list.
Eliminating Payments on a Second or Third Mortgage
As property values fall, second and third mortgages are frequently left unsecured. In other words, the property no longer has sufficient value to guarantee their payment.
EXAMPLE: Henry bought his house for $450,000 with a first mortgage of $400,000. The house quickly grew in value to $500,000, and Henry got a $40,000 loan, secured by the new equity. A year later, his house’s value has sunk to $375,000. Now Henry’s first mortgage is only partially secured, because if the house were sold now at its current value, the loan couldn’t be repaid from the proceeds. The second mortgage is completely unsecured.
If you find yourself in this situation, and you are current (or can get current) on your first mortgage, you can probably keep your house and at the same time use Chapter 7 bankruptcy to eliminate the amount you owe on the second or third mortgage. This is because the bankruptcy would discharge your obligation on the promissory note. However, the liens placed on your property by the mortgage holders would remain after your bankruptcy. Even so, the liens could not, as a practical matter, be enforced unless you tried to sell the house or the house got valuable enough to make foreclosure worthwhile.
A little background may help you better understand this point. Whenever you take out a mortgage or deed of trust, two legal claims are created:
- a claim for the debt (created by a promissory note) that can be enforced by a lawsuit, and
- a lien on the property itself, which uses the property as security for the debt.
As mentioned, a bankruptcy discharge will eliminate the debt created by the promissory note, but not the lien that the mortgage or deed of trust creates on the house.
In Henry’s case, the second mortgage lender is in a difficult position if Henry stops making payments on the second mortgage. The lender technically has the right to foreclose, but that wouldn’t make financial sense, because a foreclosure sale wouldn’t produce enough money to pay off even the first mortgage lien—and so wouldn’t generate anything at all for the second mortgage lender. (The first mortgage, used to buy the house, always has priority over later ones.) As a practical matter, all the second mortgage lender can do is to sue Henry on the promissory note ($40,000), which Henry continues to owe. But if Henry files for Chapter 7 bankruptcy, he can permanently discharge his obligation under the promissory note. The lender would be left with a lien on Henry’s house that would be unenforceable as a practical and economic matter unless the house’s value surged back up.
This is a very hard concept to understand, and if your head is swimming, you’re not alone. Perhaps another example will clear it up. If you have a second or third mortgage on your house, it’s worthwhile staying with this.
EXAMPLE: Three years ago, Paula borrowed $250,000 from a local bank to buy her first house, which cost $260,000. She borrowed $10,000 from her parents for her down payment. The bank loan is secured by a first mortgage on the house, while the loan from Paula’s parents is a personal loan; it wasn’t accompanied by a security agreement pledging the house as collateral.
Over the next two years, the value of Paula’s house increased to $350,000. She took out a $35,000 home equity loan to remodel her kitchen and landscape her backyard. As with the first mortgage, the home equity loan was secured by the house. At this point, Paula still had $55,000 equity in her home ($350,000 minus the $260,000 mortgage and the $35,000 the home equity loan). If Paula had stopped paying on the home equity loan, the lender could have foreclosed; the sale probably would have produced enough money to pay off the first mortgage and the $35,000 home equity loan. Any money left over would have been returned to Paula.
But over the last few months, the value of Paula’s house has sunk from $350,000 to $225,000. Paula has lost her job and can’t keep making payments on the home equity loan. The home equity loan lender sends her messages threatening foreclosure, but a HUD-approved housing counselor tells Paula that a foreclosure action is highly unlikely because the lender would get nothing from the sale—every penny from the foreclosure sale would go toward paying off the first mortgage.
After a while, the home equity lender sues Paula to recover the amount of the loan. Paula files for Chapter 7 bankruptcy and gets a discharge of all her debts, including the unsecured loan from her parents and the debts owed on her first mortgage and the home equity loan. The lawsuit filed by the home equity lender against Paula is dismissed. However, the bankruptcy doesn’t affect the liens that the mortgage lender and home equity loan lender have on Paula’s home. Just as before the bankruptcy, as long as the value of the house isn’t enough to pay any portion of the home equity loan if the house were sold at a foreclosure sale, foreclosure by that lender is out of the question.
Years later, property values shoot up again, and Paula’s house is worth about $300,000. The home equity lender moves to foreclose on the property because there is now enough equity to pay off both the first mortgage ($250,000) and the $35,000 home equity loan.