Should I Reaffirm My Home in Bankruptcy if It's Underwater?

It's almost always a bad idea to reaffirm your home loan in bankruptcy, especially if you owe more than the house is worth.

If you reaffirm your house in bankruptcy when it’s underwater (it’s underwater if you owe more to the lender than the house is worth), you may end up being responsible for paying the deficiency balance if you later default on mortgage payments and the lender forecloses. While there are some benefits to reaffirming a home loan, those benefits are often outweighed by the risk of being personally responsible for a large amount of debt down the line.

How Are Secured Debts Treated in Bankruptcy?

Your home loan is a secured debt. A secured debt has two components: personal liability and the security interest. The personal liability is your agreement to pay the debt. The security interest is the property that put up as collateral in order to guarantee payment of the debt (in the case of a home loan, your home is the collateral). If you default on your payment obligations, the lender can take the collateral back. In the home loan context, this is called foreclosure. (Learn more about secured debts and how lenders collect them.) (Unsecured debts, in contrast, don’t have any property guaranteeing payment. Examples include medical bills and most credit card debts.)

In bankruptcy, your personal liability for a secured debt is discharged, but not the security interest. That means that the secured creditor retains the right to repossess the collateral. So even if you are no longer personally liable for the debt (meaning the creditor cannot sue you for payment), if you stop making payments the credit can still repossess the collateral.

What Is a Reaffirmation Agreement?

When you file for bankruptcy, you are able to discharge (wipe out) many types of debts. If, however, you don’t want a particular debt to be wiped out, you can reaffirm it, that is, sign an agreement with the lender that waives the bankruptcy discharge of that debt. If you reaffirm the debt, you are once again responsible for paying it, despite your bankruptcy. (Learn more about reaffirmation agreements in bankruptcy.)

Why Would I Want to Reaffirm a Debt?

You are not required by law to enter into a reaffirmation agreement on any debt. However, when it comes to debts secured by personal property (like a vehicle), you might have a good reason to reaffirm the underlying debt. This is because most creditors will take back the collateral if you don’t reaffirm the debt. So, for example, if you want to keep your car you will probably have to sign a reaffirmation agreement (another option is to redeem the vehicle.)

Home loans are different. You can usually keep your house as long as you continue to make payments without reaffirming the debt. Mortgage lenders will not foreclose on property, or try to take the property back, as long as you remain current on your payments, and don’t default on the loan. For this reason, there’s usually not a good reason to reaffirm. The downside to reaffirmation usually outweighs the benefits.

Benefits to Reaffirming a Home Loan

There are a few reasons why you might want to reaffirm a home loan. If you discharge your personal obligation to pay mortgage debt in bankruptcy, many lenders will stop sending you monthly statements and won’t report your ongoing payments to the credit reporting agencies. (Some bankruptcy attorneys believe that a lender’s refusal to send statements is a violation of the law; this seems to be an open question right now.)

If you enter into a reaffirmation agreement, however, your lender will continue to send you statements, and permit you to take advantage of automatic payments and online banking. It will also report your payments to the credit reporting agencies, which can help you reestablish your credit after bankruptcy. In addition, your lender may be more willing to work with you in the future to refinance the loan.

Keep in mind that not all lenders will suspend automatic payment and online banking privileges, or stop sending statements, if you do not reaffirm. Some may do so temporarily when the bankruptcy is filed, and be willing to reinstate them once the bankruptcy case is closed.

Risks of Reaffirming a Home Loan

Despite the possible benefits, it is rarely a good idea to reaffirm a home loan. This is because if you do reaffirm, and your house is underwater, you could be on the hook for a large sum of money down the line if you default on your home loan. Here’s why.

Deficiency After Foreclosure

If you default on your home loan, or stop making the payments, your lender can foreclose on the property and sell the house at auction. If the house sells for less than the amount of the loan, you may owe the difference to the lender – called a deficiency balance. (Get details on when you might be liable for a deficiency after foreclosure.)

Example. Say you owe $250,000 on the loan before defaulting on the payments. The lender forecloses the property, and the house sells for $190,000. There would be a deficiency balance of $60,000.

Deficiency If You Do Not Reaffirm

If you did not reaffirm the home loan in your bankruptcy, you are not personally liable for the debt. This means that if the lender forecloses in the future, it can take possession of the house but it cannot pursue you for any deficiency.

Deficiency If You Do Reaffirm

If you reaffirmed the home loan, you agreed to still be personally liable for the home loan. If the lender forecloses and there’s a deficiency, you may be liable for paying the deficiency balance to the lender. Whether you will owe it or not depends largely on which state you live in. Some states, called recourse states, permit lenders to pursue debtors for deficiency balances owed on home mortgages. (Learn the difference between recourse and nonrecourse loans.) Other states, called non-recourse states, do not permit collection of deficiency balances on home mortgages. (To find out the law in your state, visit Deficiency After Foreclosure in Your State and click on your state link.)

If you owe the deficiency balance, and don’t pay it, the lender can sue you and get a judgment against. While you could discharge this debt in a later bankruptcy, you’ll have to wait a certain number of years after your last bankruptcy discharged in order to do so. (See Multiple Bankruptcy Filings: When Can You File Again?) This means you may owe a huge sum of money for a number of years, during which the creditor can garnish your wages, take funds from your bank account, attach your tax refunds, and more. (Learn more about ways creditors can collect judgments.)

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