Filing for Chapter 7 bankruptcy will wipe out your mortgage loan, but you’ll have to give up the home. Why? Your lender’s right to foreclose doesn’t go away when you file for bankruptcy (although bankruptcy’s automatic stay will stop the foreclosure temporarily). So, if you want to keep the house, you must continue paying your mortgage payment.
(Learn more by reading Will I Lose My Home If I File for Chapter 7 Bankruptcy?)
A mortgage loan is a secured debt. When you entered the loan contract, the lender created a lien on the property by taking the home as collateral to secure payment of the loan. If you don’t pay your mortgage, the lender can enforce its lien by foreclosing on the house. It’s the lien that makes the mortgage a secured debt.
Even though your Chapter 7 discharge wipes out your obligation to pay back the loan, it doesn’t eliminate the mortgage lien. If it did, everyone could file bankruptcy and then own their homes free and clear. As a result, if you want to keep your home, you need to continue making timely mortgage payments (or file for Chapter 13 and catch up on the arrears).
Secured Debt and Liens: What You Need to Know
A creditor is “secured” if it has the right to take a borrower’s property to satisfy the borrower’s debt. By contrast, an unsecured creditor—such as a credit card or utility company—is limited to calling or sending letters asking for payment (unless the creditor files a collection lawsuit in court, wins, and gets a money judgment).
A lien can be voluntary or involuntary.
- Voluntary liens. Typically, secured creditors include mortgage companies and car lenders. In both transactions, the borrower voluntarily agrees to guarantee the loan by giving the lender an interest (lien) in the property purchased (collateral) with the loan proceeds. For instance, when taking out a home loan, the borrower gives the lender a lien by agreeing to put up the house as collateral. If the homeowner falls behind on the payment, the bank can initiate a foreclosure proceeding, sell the home at auction, and use the proceeds to pay down the loan. A car buyer gives a lender similar lien rights when financing a vehicle. If the borrower doesn’t pay as agreed, the creditor can repossess the car, sell it at auction, and apply the money toward the loan balance.
- Involuntary liens. Not all liens are voluntary. If you fail to pay your income taxes, the federal government can take steps to obtain a lien against your assets without your consent (involuntary lien). An unsecured creditor can do the same by filing a lawsuit and winning a judgment for the amount you owe. While most voluntary liens are limited to particular property, such as a home, car, or boat, an involuntary lien can extend to all of a debtor’s assets.
A lien gives a secured creditor the right to get paid before other creditors—including in bankruptcy. If the trustee sells the encumbered property (property with a lien on it) in a Chapter 7 case, the trustee must pay the secured creditor before paying other creditors. If the property has multiple liens, the trustee will pay each lien according to the “first in time” rule (the earliest lien gets paid first).
Example. Josh financed a $20,000 sailboat with the Big Boat Company. As part of the contract, he agreed to give Big Boat a lien on the sailboat. Three years later, Josh filed for Chapter 7 bankruptcy. His debt totaled $120,000, $5,000 of which he still owed to Big Boat. The trustee sold the sailboat for $15,000. Because Big Boat had a lien against the boat, the trustee paid Big Boat the balance of $5,000 and distributed the remaining $10,000 (minus trustee fees) to the other creditors.
In a Chapter 13 case, the filer must have sufficient income to pay all monthly secured payments, such as a house or car payment. If any funds remain, the trustee will distribute them to the unsecured creditors.
Example. Jessie filed a Chapter 13 case to stop a foreclosure sale. She was required to make a monthly payment of $2,500 for five years. Out of the monthly payment, the trustee paid $2,100 to the mortgage company (the monthly payment plus a portion of the mortgage arrearages) and a $300 car payment. The trustee divided the remaining $200 between Jessie’s unsecured creditors—three credit cards, an overdue electric bill, and an unpaid gym contract.
Lien stripping is the process of removing junior liens (such as second or third mortgages) from your house if the balance of your first mortgage (or other senior liens) exceeds the value of the property.
Lien stripping isn’t available in Chapter 7 bankruptcy. If you keep the house, all liens will remain, and the lender on each loan will be able to exercise lien rights if you fall behind on your payments.
If your home equity is upside down, you might be able to strip your junior mortgage lien through Chapter 13 bankruptcy. In that case, it might be more advantageous to file for Chapter 13 bankruptcy even if you qualify for Chapter 7. (Find out if you can strip off a junior lien in Chapter 13.)
Most people who want to keep their home will make sure that they’re current on their mortgage payments before filing for Chapter 7 bankruptcy (and they’ll need to be sure that they can protect all of the equity with a bankruptcy exemption).
If you’re behind on your payment and need time to catch up on your arrears, a Chapter 13 bankruptcy is the better choice. You’ll be able to pay missed payments in your three- to five-year repayment plan. (Find out how to keep your house in Your Home in Chapter 13 Bankruptcy.)