Can You File Bankruptcy on a Home Equity Loan?

Home equity loans (HELs) present a complex challenge when individuals consider filing for bankruptcy. These financial products allow homeowners to borrow against the equity built in their property. The way a home equity loan is handled in bankruptcy proceedings differs considerably from other forms of debt, primarily because it is secured by the borrower’s home. Understanding these distinctions is important for anyone navigating financial difficulties that might lead to bankruptcy.

Understanding Home Equity Loans as Secured Debt

A home equity loan (HEL) or a home equity line of credit (HELOC) functions as a second mortgage, meaning the borrower’s home serves as collateral. This makes it a secured debt, unlike unsecured debts such as credit card balances or medical bills. This fundamental difference is crucial in bankruptcy, as it dictates how creditors can pursue repayment and what happens to the underlying asset.

If payments are not made as agreed, the lender generally has the right to take possession of the collateral. For a home equity loan, this means the lender can initiate foreclosure proceedings to recover the outstanding balance. While bankruptcy can discharge a borrower’s personal obligation to repay the debt, the lender’s lien on the property typically remains. This distinction is significant because even if personal liability is eliminated, the lender’s right to pursue the home through foreclosure for non-payment persists. Homeowners often must continue making payments on their home equity loan if they wish to keep their property, regardless of a bankruptcy filing.

Impact of Chapter 7 Bankruptcy on Home Equity Loans

Chapter 7 bankruptcy involves the liquidation of non-exempt assets to pay creditors. The primary goal for debtors is often the discharge of personal liability for debts. For a home equity loan, Chapter 7 can indeed discharge the borrower’s personal obligation to repay the loan, meaning the individual is no longer legally responsible for the debt.

However, the lender’s lien on the home typically survives a Chapter 7 discharge. This means that while the borrower is no longer personally liable, the lender still holds a claim against the property itself. If payments are not continued, the lender retains the right to initiate foreclosure proceedings to satisfy the debt. To retain their home, debtors in Chapter 7 have a few options regarding their home equity loan.

Reaffirmation: The debtor agrees to remain personally liable for the debt despite the bankruptcy discharge. This legally binding agreement is filed with the bankruptcy court and requires the debtor to continue making payments to avoid foreclosure and keep the home.
Surrender: If a homeowner decides they cannot afford or no longer wish to keep the property, they can surrender it to the lender. In this scenario, the debt, including the home equity loan, is discharged, and the homeowner is relieved of any personal liability or future obligations related to the property. The lender can then proceed with foreclosure.
Redemption: This allows a debtor to pay the creditor the fair market value of the secured property in a single lump sum, effectively clearing the lien and retaining ownership. This option is more commonly used for personal property, such as vehicles, where the value is significantly less than the loan balance and a lump sum payment is feasible. Due to the substantial amounts involved, redeeming a home equity loan on real estate is rarely a viable path.

The homestead exemption also plays a role in Chapter 7, protecting a certain amount of equity in a debtor’s primary residence from creditors. While this exemption helps safeguard a portion of the home’s value from being used to pay unsecured debts, it does not eliminate the secured lien of a home equity loan. The discharge of personal liability under Chapter 7 does not remove the lender’s security interest in the property, underscoring the importance of continued payments if the goal is to keep the home.

Impact of Chapter 13 Bankruptcy on Home Equity Loans

Chapter 13 bankruptcy allows individuals with a regular income to reorganize their debts through a court-approved repayment plan. This plan typically spans three to five years, during which the debtor makes consistent payments to a trustee, who then distributes funds to creditors. Chapter 13 offers more flexibility for homeowners facing financial distress related to their home equity loans compared to Chapter 7.

One significant benefit of Chapter 13 is the ability to cure arrearages on a home equity loan. If a debtor has fallen behind on HEL payments, the Chapter 13 plan can incorporate a mechanism to catch up on these missed payments over the life of the plan, typically 36 to 60 months. This allows the homeowner to prevent foreclosure while continuing to make regular ongoing payments as they become due. The plan must demonstrate the debtor’s ability to make all required payments, including the regular HEL installments and the arrearage cure.

Lien stripping is another powerful tool available for home equity loans in Chapter 13, under specific circumstances. This process allows a junior lien, such as a second mortgage or home equity loan, to be reclassified as an unsecured debt. For lien stripping to be possible, the value of the home must be less than the outstanding balance of the first mortgage. If a home equity loan is successfully stripped, it is then treated like other unsecured debts in the repayment plan, often receiving only a small percentage of the original amount or no payment at all. If even a small amount of equity exists to secure the home equity loan, lien stripping is generally not permitted.

Cramdown, a provision that allows debtors to reduce the principal balance of certain secured debts to the value of the collateral, is generally not applicable to a debtor’s primary residence. While cramdowns can be used for other types of secured property, such as vehicles or investment properties, they cannot typically be used to reduce the principal balance of a home equity loan on a primary residence. This limitation ensures that lenders on primary residences maintain their full secured claim.

Payments for a home equity loan are integrated into the Chapter 13 payment plan. This provides a structured approach to managing the debt, allowing debtors to potentially adjust payment terms or extend the repayment period. The ability to cure arrearages and, in specific cases, strip junior liens makes Chapter 13 a viable option for many homeowners seeking to address home equity loans in bankruptcy.