What Happens If You File Bankruptcy With a Mortgage?

Filing for bankruptcy with a mortgage adds complexity to the legal process. Individuals considering this path aim to alleviate overwhelming debt, but must carefully consider the impact on their primary residence and its loan. This article explains the general implications for homeowners navigating bankruptcy with a mortgage.

How Bankruptcy Chapters Address Mortgages

The chosen bankruptcy chapter significantly shapes how a mortgage is handled. Chapter 7 and Chapter 13, the most common forms of consumer bankruptcy, treat secured debts like mortgages distinctly. These differences impact a debtor’s ability to retain their home and dictate the framework for managing a mortgage during bankruptcy.

Chapter 7, often called liquidation bankruptcy, discharges unsecured debts like credit card balances or medical bills. While it eliminates a debtor’s personal liability for a mortgage loan, it does not remove the mortgage lien from the property. The lender’s right to foreclose if payments are not made remains intact, as a mortgage is collateralized by the home itself.

In a Chapter 7 filing, if a debtor possesses non-exempt home equity, the bankruptcy trustee may sell the home to pay creditors. The trustee liquidates non-exempt assets to distribute proceeds. A home sale is pursued only if the available equity, after accounting for secured debts and exemptions, is substantial enough for a meaningful distribution to unsecured creditors. If equity is minimal or fully protected by exemptions, the trustee may choose not to sell the property.

Conversely, Chapter 13 bankruptcy involves a reorganization plan, allowing individuals with regular income to repay debts over three to five years. This chapter benefits homeowners behind on mortgage payments who wish to keep their homes. It provides a mechanism to address delinquent mortgage payments and maintain ongoing ones, preventing foreclosure.

Chapter 13 also offers “lien stripping” for junior liens, such as second mortgages or home equity lines of credit (HELOCs). Lien stripping is possible if the home’s value is less than the first mortgage’s outstanding balance. In this scenario, the junior lien is considered wholly unsecured and reclassified as general unsecured debt within the Chapter 13 plan. This means the second mortgage or HELOC is no longer secured by the home, and the debtor may pay only a percentage of that debt, similar to other unsecured creditors. The lien is discharged only if the Chapter 13 plan is successfully completed.

Options for Retaining or Relinquishing Your Home

Homeowners facing bankruptcy have several choices regarding their primary residence and mortgage. These options allow for retaining the home and continuing payments, or relinquishing the property and discharging the associated debt. The decision depends on the debtor’s financial capacity, home equity, and long-term housing goals.

Reaffirmation

One option, primarily available in Chapter 7 bankruptcy, is “reaffirmation.” This involves a debtor formally agreeing to remain personally liable for a mortgage debt after discharge. This agreement exempts the mortgage from discharge, allowing the debtor to keep the home and continue payments. Reaffirmation agreements must be court-approved, with the court assessing affordability and the debtor’s best financial interest. If a debtor reaffirms and then defaults, the lender can pursue collection actions, including foreclosure and seeking a deficiency judgment.

Surrender

Another choice is to “surrender” the home, giving up the property to the lender. When a debtor surrenders the home in bankruptcy, their personal liability for the mortgage debt is discharged. This means the lender cannot pursue them for any deficiency balance after the property is sold through foreclosure. This option is available in both Chapter 7 and Chapter 13 bankruptcies, providing relief from an unaffordable mortgage or a property with little equity. Surrendering the home eliminates the ongoing financial burden.

Redemption

“Redemption” is a less common option for homes, primarily used in Chapter 7. It allows a debtor to keep secured personal property by paying the lender the fair market value in a single lump sum. While applicable to real estate, it is rarely practical for a primary residence due to the substantial cash required. Redemption is more frequently used for items like vehicles or household goods where market value is less than the outstanding loan balance.

Curing Arrears

For debtors in Chapter 13 bankruptcy, “curing arrears” is a strategy to save a home from foreclosure. This option allows the debtor to pay back all missed mortgage payments, including fees or penalties, over the Chapter 13 repayment plan’s duration, up to five years. Debtors must also continue making regular, ongoing mortgage payments. This structured repayment provides a feasible way to catch up on a defaulted mortgage and prevent home loss.

Mortgage Modification

Bankruptcy courts cannot modify primary mortgage terms on a principal residence. However, Chapter 13 can facilitate “mortgage modification” through other avenues. Debtors can pursue loss mitigation options directly with their lender, sometimes with court-sponsored mediation programs.

These programs help debtors and lenders reach agreeable solutions, such as loan modifications that might adjust interest rates, extend loan terms, or reduce monthly payments. Such modifications are not guaranteed and are at the lender’s discretion. If approved, a modification requires court confirmation to be incorporated into the Chapter 13 plan.

Protecting Home Equity Through Exemptions

Bankruptcy exemptions protect a debtor’s home equity, particularly in Chapter 7 cases. An exemption is a legal provision allowing a debtor to keep a certain amount of property from being sold by the bankruptcy trustee to pay creditors.

Homestead Exemption

The “homestead exemption” specifically protects a portion of the equity in a debtor’s primary residence. The protected equity amount varies significantly based on whether the debtor uses federal or state exemptions. Most states have their own homestead exemption laws, with amounts differing widely. Debtors choose the exemption system providing the most protection for their assets.

In practice, if a debtor’s home equity is fully covered by the applicable homestead exemption, the Chapter 7 trustee cannot sell the home. For example, if a home is valued at $300,000 with a $250,000 mortgage, there is $50,000 in equity. If the state’s homestead exemption protects $75,000 of equity, the home is safe from liquidation by the trustee.

However, if the home’s equity exceeds the exemption amount, the trustee may sell the property. The trustee would sell the home, pay off the mortgage, distribute the exempt portion of equity to the debtor, and use remaining funds to pay unsecured creditors. The decision to sell also considers sale costs, ensuring a meaningful distribution to creditors after all expenses and the debtor’s exemption are accounted for.

The Automatic Stay and Mortgage Creditors

Upon filing a bankruptcy petition, the “automatic stay” comes into effect. This legal injunction provides debtors with immediate relief from most collection activities. Its purpose is to halt creditor actions and give the debtor a temporary reprieve to reorganize financial affairs under court protection.

The automatic stay instantly stops most collection efforts, including lawsuits, wage garnishments, repossessions, and foreclosure proceedings. For mortgage creditors, this means they cannot initiate or continue foreclosure actions, send demand letters, or engage in collection communications once the bankruptcy case is filed. This provides breathing room for homeowners to explore options for saving their home without the immediate threat of losing it.

While the automatic stay is broad, it is not always permanent. Mortgage creditors can ask the bankruptcy court to “lift the automatic stay” by filing a motion for relief from stay. The court may grant this motion if the debtor is not making post-petition mortgage payments, there is no equity in the property for the bankruptcy estate, or the property is not necessary for an effective reorganization.

If the court grants the motion, the mortgage creditor is permitted to resume collection activities, including foreclosure, outside of the bankruptcy process. The automatic stay serves as a temporary shield, offering debtors a window of opportunity to address their mortgage obligations. It requires continued compliance with payment terms or a viable plan for resolution to remain in effect.