What Happens to a Mortgage in Bankruptcy?

Bankruptcy offers individuals a legal pathway to address financial burdens. For many homeowners, a significant concern is understanding their mortgage’s fate. Bankruptcy law provides frameworks for managing secured debts like home loans, allowing debtors to reorganize finances or obtain relief from obligations. It aims to provide a fresh financial start, though mortgage implications vary depending on the bankruptcy type filed.

Initial Impact of Bankruptcy Filing

Filing for bankruptcy immediately triggers an “automatic stay,” a legal injunction. This court order temporarily halts most collection activities from creditors, including foreclosure proceedings, repossessions, wage garnishments, and lawsuits. The purpose of the automatic stay is to provide debtors a temporary reprieve, allowing them to organize their financial affairs under bankruptcy court supervision. It ensures no single creditor gains an unfair advantage by seizing assets before a comprehensive plan is established for all creditors.

While the automatic stay is a broad protection, it is temporary and does not eliminate the underlying debt. In a Chapter 7 bankruptcy, the stay lasts for about three to four months until the case is completed and eligible debts are discharged. For Chapter 13 cases, the stay can remain in effect longer, spanning the entire three to five-year repayment period. Creditors can, however, file a “motion for relief from stay” to ask the court to lift this protection, particularly if they can demonstrate a lack of equity in the property or if the debtor is not making required payments. If granted, this motion allows the creditor to resume collection efforts, such as continuing a foreclosure.

Mortgage Treatment in Chapter 7

Chapter 7 bankruptcy, referred to as liquidation bankruptcy, aims to discharge unsecured debts like credit card balances or medical bills. However, secured debts like mortgages are treated differently as they are backed by collateral—the home itself. Debtors in Chapter 7 have several options regarding their home and mortgage.

One common choice is to surrender the property. This means the debtor voluntarily gives up the home to the lender, and in return, is relieved of personal liability for the mortgage debt. Any “deficiency balance,” the difference between the outstanding loan amount and the home’s sale price after foreclosure, is also discharged in bankruptcy. This option is chosen when a homeowner can no longer afford payments or the home’s value is less than the amount owed.

Another option for debtors who wish to keep their home is reaffirmation. This is a formal agreement to continue making mortgage payments despite the bankruptcy discharge, making the debtor personally liable again. Reaffirmation allows the debtor to retain ownership of the home, but it requires adherence to the original loan terms or renegotiated terms. The agreement must be filed with the court and requires court approval to ensure it is in the debtor’s best interest.

A third option is redemption. Redemption allows a debtor to pay the lender the current market value of the property in a lump sum, rather than the full loan amount. This option is practical when the property’s value is significantly lower than the debt and the debtor has access to funds. Due to the substantial lump sum payment required, redemption is rarely used for real estate.

Home equity significantly influences mortgage treatment in Chapter 7. If the home has substantial equity that is not protected by a “homestead exemption,” the bankruptcy trustee may sell the home to pay creditors. Homestead exemptions shield equity in a primary residence from creditors. Protection amounts vary by law. If the equity falls within the exemption limit, or if there is no non-exempt equity, the debtor can keep the home by continuing to make payments or by reaffirming the debt.

Mortgage Treatment in Chapter 13

Chapter 13 bankruptcy, or reorganization bankruptcy, offers a different approach, allowing individuals with regular income to repay debts through a court-approved plan. This repayment plan spans three to five years. Chapter 13 is chosen by homeowners who want to keep their homes and catch up on overdue mortgage payments.

One of the benefits of Chapter 13 is the ability to “cure defaults” on a mortgage. If a debtor has fallen behind on payments, the Chapter 13 plan allows them to repay the missed amounts, known as arrearages, over the life of the plan. While catching up on past-due amounts, debtors must also continue regular monthly mortgage payments. This structured repayment mechanism can prevent foreclosure and help homeowners retain their property.

Chapter 13 also offers a tool called “lien stripping,” for junior mortgages or home equity lines of credit (HELOCs). If the fair market value of the home is less than the balance owed on the first mortgage, any junior liens can be reclassified as unsecured debt. For instance, if a home is worth $300,000 and the first mortgage is $400,000, a second mortgage of $100,000 can be stripped.

This reclassification means the junior lien is treated similarly to credit card debt, receiving a small percentage or nothing through the payment plan. Upon successful completion of the Chapter 13 plan, the stripped junior lien is discharged, and the lender is required to remove it from the property. This process is exclusively available in Chapter 13 and not in Chapter 7.

Should a home eventually be foreclosed upon after the Chapter 13 discharge, the debtor is not personally liable for any deficiency balance. This protection arises because the debt was addressed and discharged through the plan. Chapter 13 provides a structured environment for debtors to manage their mortgage obligations, offering mechanisms to address past defaults and eliminate certain junior liens, while working towards a financial fresh start.