Bankruptcy and Foreclosure

Bankruptcy can provide certain relief to a defaulting or distressed home loan borrowers.

Automatic Stay. Immediately, when a borrower (debtor) files for bankruptcy relief and protection, all creditor collection and legal actions against the debtor (including foreclosure and forced sale) are stopped and put on hold automatically (This is called the “automatic stay”).  The creditor has to “stay put” and not move forward with collection or other legal action.

Bankruptcy Modification of Home Loans. Bankruptcy courts do not typically “modify” mortgages (or deeds of trust).  But see Chapter 13 Bankruptcy and also Lien Stripping below. 

Bankruptcy kills the debtor’s personal obligation but the security lien survives. The mortgage (or deed of trust) debt can be discharged (forgiven, wiped out, killed) through bankruptcy.  That means that the lender can’t later sue you and get a money judgment against you if you stop paying on the loan.  But, if you are in arrears or default, the lender can still normally recover part or all of its loan balance due by foreclosing on the property (that is, the lien or security interest survives the discharge). 

Chapter 13 Bankruptcy.  A borrower / debtor who is behind in his or her mortgage (in arrears or in default) on a home loan, by filing a Chapter 13 bankruptcy, can “reorganize” (i.e., pay less and/or have more time to catch up on) his or her debts.  His or her plan must provide that he or she will make all future reoccurring monthly payments owed on his or her home loan(s) and also get caught up (cure) over time any past due obligations (arrears) on the loan(s).  But see Lien Stripping below.

Lien-Stripping of Junior Liens.  A Chapter 13 bankruptcy debtor can get rid of junior mortgages (or deeds of trust) by “lien stripping.”  Junior mortgages are loans lower in priority than the first or original loan, for example, second and third mortgages, HELOCs, etc.)

To strip the lien, (at least in the 9^th Federal Circuit which includes California and certain other states), a Chapter 13 debtor, if he or she has a worthless junior mortgage, can have the deed of trust declared void (no longer existing). 

Worthless means that if the property were (hypothetically) sold, after payment to the first or senior loan, there would be NO money left over to pay even part of the junior loan(s); hence, they are deemed presently “worthless.”

Once the lien is stripped, the worthless junior loan(s) are treated as unsecured, non-priority debt(s).  In other words, they are treated as the low man on the totem pole along with the other unsecured debts like credit cards and medical bills.  The nonpriority, unsecured debts get the “left over” money after payment of priority and secured debts.  Therefore, often, in a Chapter 13, the total amount due on unsecured debts (including the worthless junior loans) are reduced, often very significantly. 

If the debtor fulfills (successfully completes) his or her Chapter 13 repayment / reorganization plan (which usually lasts 3-5 years), the worthless liens (junior mortgages and trust deeds) disappear permanently, and any unpaid balance on such junior liens are discharged (completely forgiven, wiped out, killed).

Chapter 7 Lien Strip by Negotiation: Chapter 7 bankruptcies don’t allow lien stripping.  But many debtors have found that a junior lienholder of a worthless security (see definition of “worthless” above), after discharge, are willing to voluntarily negotiate a substantial reduction of the lien under certain circumstances and conditions.

Relief From the Automatic Stay. A home-loan lender can obtain relief from (no longer be subject to, no longer have to obey) the automatic bankruptcy stay and can go forward with the foreclosure during the bankruptcy if it can prove that:

(1) The property has no equity, and

(2) The property is not needed for any proposed feasible (capable of reasonably succeeding) reorganization (repayment plan).   

A home-loan lender can also obtain a court order to be relieved from the automatic stay if there is sufficient cause, as for example, when the borrower does not have adequate property insurance on the home.  Also multiple and successive bankruptcy filings with an intent to merely delay foreclosure proceedings, rather than for a legitimate bankruptcy purpose is grounds for relief from the automatic bankruptcy stay.

Warning/Note: Bankruptcies are complicated and require circumspect analysis of the totality of the debtors assets, debts, income, expenses and other financial and legal matters.  You ought to and are urged to consult an experienced and knowledgeable bankruptcy lawyer if you are considering bankruptcy.

This article does not discuss Chapter 11 reorganization bankruptcy or Chapter 12 family farmer bankruptcy.

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