Can You File Bankruptcy on a HELOC Loan?

A Home Equity Line of Credit (HELOC) functions as a revolving line of credit, allowing homeowners to borrow against their property’s equity. Similar to a credit card, funds can be drawn, repaid, and re-borrowed up to a predetermined limit. A HELOC is secured by the borrower’s home, meaning the property serves as collateral.

When financial difficulties arise, individuals may consider bankruptcy to manage or eliminate overwhelming debt. This formal process aims to provide a fresh financial start by liquidating assets to pay creditors or establishing a structured repayment plan. The treatment of a HELOC in bankruptcy is a primary concern for homeowners, as it involves their most significant asset. This article explores how a HELOC is addressed during bankruptcy proceedings.

Understanding HELOCs in Bankruptcy

A fundamental concept in bankruptcy is the distinction between secured and unsecured debt, which impacts how financial obligations are handled. A HELOC is a secured debt because it is backed by the borrower’s home. The lender holds a lien on the property, providing a legal claim if the borrower fails to meet repayment terms.

Unsecured debts, such as credit card balances or medical bills, do not have specific collateral. Lenders for unsecured debts rely on the borrower’s promise to repay. Collateral grants secured creditors greater rights in bankruptcy compared to unsecured creditors, as their claim is linked to an asset.

Individual bankruptcy generally involves two types: Chapter 7 and Chapter 13. Chapter 7, or liquidation bankruptcy, may involve selling non-exempt assets to repay creditors, with qualifying debts then discharged. Chapter 13, a reorganization bankruptcy, allows debtors to keep property while repaying debts through a court-approved plan over three to five years.

The choice between Chapter 7 and Chapter 13 influences the outcome for a HELOC due to its secured nature. While bankruptcy can eliminate personal liability for a HELOC, the lien on the home typically remains intact. This means the lender retains their right to the property if payments cease. Understanding these differences is essential for comprehending the implications for a HELOC in each chapter.

Chapter 7 and HELOCs

When an individual files for Chapter 7 bankruptcy, the personal obligation to repay the HELOC debt can be discharged, eliminating the borrower’s legal responsibility. However, this discharge does not automatically remove the lien the HELOC lender holds on the home. The lien generally survives Chapter 7, meaning if payments are not maintained, the lender retains the right to foreclose to satisfy the debt, even after personal debt discharge.

Homeowners facing a HELOC in Chapter 7 have a few options. One option is to surrender the home to the lender. By surrendering, the debtor relinquishes ownership, allowing foreclosure. This eliminates personal liability for the HELOC and the lien, as the property is no longer the debtor’s responsibility.

Another possibility is to reaffirm the HELOC debt. A reaffirmation agreement is a voluntary, legally binding contract where the debtor agrees to continue making payments despite the bankruptcy discharge. This allows the homeowner to retain the property and keep the lien intact, but the debtor remains personally liable. Reaffirming requires court approval, and the debtor must demonstrate the ability to make ongoing payments, as it bypasses the debt relief typically provided by bankruptcy.

A less common option is redemption. Redemption involves the debtor paying the lender the property’s current market value in a lump sum to clear the lien, rather than the full outstanding balance. This option is generally feasible only if the property’s market value is less than the loan balance and the debtor has access to sufficient funds. The decision among these options often hinges on the homeowner’s desire to keep the property, the amount of equity, and their financial capacity to continue payments or settle the debt.

Chapter 13 and HELOCs

Chapter 13 bankruptcy offers a different framework for addressing a HELOC, involving a structured repayment plan spanning three to five years. This bankruptcy type allows individuals to reorganize debts, including a HELOC, while retaining assets. A benefit of Chapter 13 is its capacity to help homeowners prevent foreclosure by curing any arrearages on their HELOC or first mortgage over the plan’s duration.

A key feature in Chapter 13 for certain junior liens, like HELOCs, is “lien stripping.” This can reclassify a HELOC from secured to unsecured debt if the property’s value is less than the balance owed on the first mortgage. For instance, if a home is valued at $300,000 and the first mortgage balance is $320,000, any HELOC would be considered entirely unsecured due to no equity. In such a scenario, the HELOC’s lien could be stripped and treated similarly to other unsecured debts, like credit card debt, within the Chapter 13 repayment plan.

If lien stripping is successfully applied, the HELOC holder may receive only a small percentage of the original debt, or nothing, over the repayment plan. Upon successful completion of the Chapter 13 plan, the remaining unsecured portion of the HELOC debt is discharged, and the lien is permanently removed from the property. This offers substantial relief for homeowners whose property values have declined significantly, leaving their HELOC “underwater.”

However, if there is sufficient equity to cover the HELOC after accounting for the first mortgage, lien stripping is not possible. The HELOC remains a secured debt, and its payments, including any arrearages, must be included and paid through the Chapter 13 plan. The debtor must demonstrate the financial capacity to make these payments, alongside other plan obligations, for the court to confirm the plan. Chapter 13 provides a mechanism to bring overdue HELOC payments current, helping homeowners avoid foreclosure and keep their property.

Key Information Before Filing

Before considering bankruptcy for a HELOC, gathering specific financial and property information is crucial. A fundamental step is determining the home’s current market value. This can be assessed through a formal appraisal, a comparative market analysis, or by researching recent sales of comparable homes. An appraisal is often most reliable, especially if lien stripping is a potential strategy.

Next, know the precise outstanding balances on both the first mortgage and the HELOC. This information, combined with the property’s market value, allows for calculating home equity. Equity is determined by subtracting all outstanding liens, including the first mortgage and HELOC, from the home’s current market value. This calculation directly influences whether a HELOC can be lien stripped in Chapter 13 or how much equity might be exposed in Chapter 7.

Any other liens on the property, such as tax or judgment liens, should also be identified, as they affect the equity calculation and the home’s treatment in bankruptcy. Understanding current income and expenses is necessary to determine eligibility for Chapter 7, which has income limitations, or the feasibility of a Chapter 13 repayment plan. The ability to make consistent payments in a Chapter 13 plan is a prerequisite for court approval.

Homeowners should also be aware of state homestead exemptions. These exemptions protect a certain amount of home equity from creditors in bankruptcy. While specific amounts vary by state, the homestead exemption can play a significant role in determining whether a homeowner can retain their property, particularly in Chapter 7, or how much must be paid to unsecured creditors in Chapter 13. Understanding the distinction between personal liability for the HELOC debt and the secured lien is vital for making informed decisions. Gathering this comprehensive financial picture helps assess the most appropriate bankruptcy path and anticipate the likely outcome for the HELOC.