Keep Your House With Chapter 13 Bankruptcy

Chapter 13 bankruptcy is one way to avoid foreclosure. Unlike in a Chapter 7 bankruptcy, you can make up your missed mortgage payments over three to five years. It can also make paying your mortgage more affordable after bankruptcy by reducing your overall debt load.

If you can stick to your Chapter 13 repayment plan, you can:

• repay your mortgage arrears over time
• pay a portion—and sometimes nothing—toward your credit card balances, medical bills, and other unsecured debts each month, which frees up money for you to pay your mortgage
• ask the court to reduce (cram down) specific secured debts to the collateral's value (for example, you might be able to reduce your $30,000 car note to the actual value of the car and reduce your monthly payments)
• get rid of (strip off) liens on your home created by second and third mortgages if they are wholly unsecured by your home equity (that is, selling your house wouldn't generate enough money to pay back any portion of the junior lien—not even $1), and
• contest a foreclosure.

Each of these Chapter 13 benefits are described in detail below.

Repay Your Mortgage Arrears Over Time

With a Chapter 13 bankruptcy, you have an opportunity to get your mortgage current over time. However, it's important to understand that Chapter 13 bankruptcy works to keep your house only if you have enough income to make both your current payment and pay off a portion of your arrears each month (plus costs and fees). And you must propose a plan showing not only that you can make plan payments but also that you can keep current on all your other reasonable and necessary monthly expenses.

So, although filing for Chapter 13 can be a great way to save a home, it's rarely as cheap as the "pay pennies on the dollar" advertisements would make it seem. While filers often pay a small percentage of credit card balances and other unsecured debts, those debts fall into only one of several debt categories. The other debt categories can be very costly, quickly driving up monthly plan requirements.

For instance, a proposed plan must demonstrate that you earn enough to pay your monthly mortgage payment, catch up on arrears, and cover monthly expenses, such as rent, food, utilities, car payments (plus arrears, if you're behind), and insurance. But even those debts don't typically cause the most trouble.

What Are Priority Debts?

Many people can't afford a plan when they have "priority" debts that require full payment. For example, if you owe recent back taxes, the court won't approve your repayment plan unless it shows that you can pay off the entire balance while your plan is in effect. You must pay off support arrearages, too. Both of these debts can be quite substantial.

You Must Pay Unsecured Creditors at Least as Much as They'd Have Received in a Chapter 7 Bankruptcy

Another tricky rule requires you to pay your unsecured creditors at least as much as they would have received in a Chapter 7 bankruptcy, which can be challenging for those who own a lot of property. The problem arises when "bankruptcy exemptions," the laws that tell people which property they can keep, fail to protect the property's equity fully. The rule is that a filer with "nonexempt" or unprotected property equity must pay unsecured creditors an equivalent amount through the plan.

For instance, suppose you would lose a $15,000 boat in Chapter 7 because a bankruptcy exemption didn't cover it (generally, boats are unprotected luxury items that an exemption won't protect unless the filer needs it in a business or trade). In Chapter 7, the trustee would sell the nonexempt boat, deduct the sales costs and trustee's fee—assume a total of $2,500—and distribute the $12,500 in proceeds to creditors. In Chapter 13, you'd keep the boat because the Chapter 13 trustee doesn't sell property. However, you'd have to pay your unsecured creditors at least as much as they would have received in Chapter 7, or $12,500 (you'd subtract the costs and fee because you aren't required to pay more to creditors than the Chapter 7 creditors would have received).

A problem can arise when filers have significant nonexempt equity in the property they'd like to keep because it can cause the monthly Chapter 13 payment to be too high for the filer to afford—a common situation when houses are involved. For instance, suppose you have $250,000 in home equity but can exempt only $130,000, leaving $120,000 of nonexempt equity. You'd need to pay unsecured creditors $2,000 monthly for five years. You can't count the amount you pay toward your mortgage or car note because they're secured debts backed by collateral, not unsecured debts. Of course, you aren't required to pay more than you owe, so if you owed less than $120,000 to unsecured creditors, you'd pay them in full in what is known as a "100%" plan.

Chapter 13 Isn't Free

Finally, Chapter 13 isn't free. Your plan must pay the trustee up to 10% of the amounts paid to creditors through the repayment plan. This fee covers the trustee's operating costs. (The one-time filing fee funds the court's Chapter 13 bankruptcy program administration.)

If you live in a jurisdiction that requires filers who are behind on their mortgage to pay the monthly mortgage payment through the plan, the trustee's fee will be steep. For instance, you'd pay $300 monthly to the trustee for a $3,000 mortgage payment, plus 10% on any additional amount paid through the plan.

Make Your Mortgage More Affordable by Eliminating Other Debts

Even though Chapter 13 can be expensive, your ability to pay significantly less toward other debts can make the payment manageable, depending on your financial picture. Also, because Chapter 13 addresses all debts, you can count on being in a much better financial position once you complete the plan, leaving you better equipped to keep your house when you emerge from bankruptcy. Ultimately, after Chapter 13, most people can expect to be free of debt except for a mortgage and student loans.

Secured Debts

You've likely already recognized that your plan must address other secured debts, like auto loans, tax liens, and other obligations secured by property. They're treated much like your mortgage. You must make the monthly payments to keep the car, truck, or other collateral and catch up on arrearages. Most of these debts will be paid in full during the plan because the time remaining on the payment plan will be less than the duration of the Chapter 13 plan.

The exception is "long-term" debt, which requires payments for more than three or five years. Typically, the number of payments left on your mortgage will make it a long-term debt. Financed vehicles and student loans can also fall into this category. You'll continue making the remaining monthly payments after completing the repayment plan.

Unsecured Debts

Your "unsecured debt," or those obligations not secured by a property lien, is treated differently. For most people, unsecured debt will include everything besides their mortgage and car payments. Your plan will likely pay less than you would typically pay on credit card balances, medical bills, personal loans, and other unsecured debts you can discharge in bankruptcy. The bankruptcy court eliminates whatever remains owing on these qualifying obligations at the end of the repayment plan.

By contrast, you won't be able to discharge nonqualifying unsecured "priority" debt, like support obligations, and most recently incurred unsecured tax debt. You'll pay these debts in full through your plan.

Student Loans

Student loans don't fit neatly into the unsecured debt categories. Student loans aren't priority debts, and you aren't required to pay them off in your plan. You might even pay less than you would through your usual monthly payment. However, unless you file a separate lawsuit and prove that your income will remain so low that requiring you to pay the loans would be an "undue burden," you'll remain responsible for student loan balances after bankruptcy.

Ask the Court to Reduce ("Cram Down") Certain Secured Debts

You aren't always required to pay the full amount owed on your mortgage, car payment, and other secured debts. Chapter 13 bankruptcy judges can reduce, or "cram down," certain secured debts to the market value of the collateral securing it. They can also lower interest rates to the going rate in bankruptcy cases (usually a few points above the prime rate).

Paying less on a balance or interest will give you more money to pay toward your mortgage and a better chance at proposing a "confirmable" Chapter 13 plan that the court will approve.

A cramdown is usually available only for:

• cars bought at least 910 days before you file for bankruptcy (check your jurisdiction's requirements)
• other personal property items (furniture, jewelry, computers) bought at least one year before filing
• rental or vacation homes (but not your primary residence), and
• loans on mobile homes that your state classifies as personal property (not real estate).

The catch is that you must repay the entire cramdown amount in your plan. As a result, most people can't afford to use it to reduce the balance owed on real estate.

Contest a Foreclosure

You might be able to fight a foreclosure in your state's courts whether or not you file for bankruptcy. However, if you file for Chapter 13 bankruptcy, you can ask the bankruptcy court to decide whether the proposed foreclosure facts are erroneous. For example, suppose you contest a foreclosure because your mortgage servicer failed to credit some payments. A bankruptcy court decision in your favor might eliminate the basis for the foreclosure. Depending on your jurisdiction, your bankruptcy court might be more sympathetic to a foreclosure challenge than the state court.

The ability to stop a foreclosure action in Chapter 13 is powerful, and some people try to use it to defraud creditors. For instance, filing a questionable case to stop a foreclosure and refiling as soon as the bankruptcy court dismisses it can land you in big trouble. It can take a while for the court to spot a bad-faith filer. But when it finally does, not only will the judge ban the debtor from further filings (temporarily or permanently), but refer the case to the U.S. Attorney's office for a perjury prosecution if there are any significant misstatements in the paperwork.

Wipe Out a Second or Third Mortgage

If you're like many homeowners, you might have taken out several loans when purchasing your home, and encumbered it with a first and second mortgage (often the case in an 80–20 financing arrangement). It also wouldn't be uncommon to have later added a third mortgage, possibly a home equity line of credit or "HELOC."

Typically, you must pay the monthly payments on debts secured by your home and any arrearages when filing for Chapter 13 if you want to keep the house (plus pay for any nonexempt home equity, as discussed above). However, one of Chapter 13 bankruptcy's great features is the ability to strip off mortgages not secured by your home equity when your home isn't worth as much as you owe.

Bankruptcy Judge Can "Strip" Liens

When your house is worth less than you owe, the bankruptcy judge can "strip" the liens from entirely unsecured junior mortgages and reclassify them from secured to unsecured debts in your plan (you must use a motion or hearing procedure asking the court to do this—it isn't automatic). As a result of the reclassification, you repay a small portion of stripped loans along with other unsecured debts like credit card balances and medical bills. And at the end of your case, the judge erases any remaining balance. You aren't responsible for paying any lien-stripped mortgage loans or HELOCs after your bankruptcy.

For example, suppose your home's first mortgage is $300,000, the second mortgage is $75,000, and you owe a $50,000 HELOC. Presumably, the value of your home when you took on these debts was at least equal to the total value of the mortgages, or $425,000. But if the house's value falls below $300,000, it no longer secures the second and third mortgages. Selling the house wouldn't bring enough money to pay all encumbrances. After paying the first mortgage, nothing would remain for the second or third mortgage holders—not even $1 (the rule is that if you can pay even $1 toward the mortgage, you can't strip the lien). In this instance, you could strip the liens from the second mortgage and HELOC in Chapter 13 and pay them as unsecured debts. At the end of the repayment plan, you'd only owe the balance on the first mortgage—the bankruptcy court would discharge the remaining balances on the second and HELOC.

The ability to strip wholly unsecured liens is a good bargain because having a large amount of dischargeable debt doesn't increase your payment. You pay whatever amount of disposable income you have into the plan, and the trustee divides it among all dischargeable creditors. You'll pay the same amount regardless of whether the mortgages are in the unsecured debt group—adding more creditors to the category simply means they'll each receive less money.

Another benefit? If the court allows you to strip junior liens, you won't have to make up payments missed on the junior mortgages, which could reduce the required total monthly payment considerably. Finally, once the bankruptcy court removes the lien from your property, the former lender won't have any right to collect payment or to recover your property—even if your home value increases.

Get More Information About Foreclosure and Chapter 13 Bankruptcy

This article is a modified excerpt from The Foreclosure Survival Guide by Attorneys Amy Loftsgordon and Cara O'Neill (Nolo). If you're having trouble making your mortgage payments or are in jeopardy of foreclosure, this guide will give you the practical information you need. While filing for Chapter 13 bankruptcy is one way to avoid foreclosure, there are other options to consider, such as getting a loan modification.

Nolo also offers books specifically covering filing for bankruptcy, including How to File for Chapter 7 Bankruptcy and Chapter 13 Bankruptcy, both by Cara O'Neill (Nolo).