Foreclosure and Bankruptcy

Imminent foreclosure is what prompts many people to file for bankruptcy. In general, a Chapter 7 bankruptcy will not prevent foreclosure, but it may be prevented by filing for Chapter 13, which requires a repayment plan. However, qualifying for a Chapter 13 bankruptcy requires a sufficient income to pay all of your secured and priority debts, and at least 25% of your unsecured debt, or the value of your nonexempt assets, whichever is greater.

The Process of Foreclosure

Foreclosure is a legal procedure that allows property that was used as security for a loan to be sold to repay the loan when the borrower has defaulted. All junior liens are eliminated in the process.

If you default on a loan for property that secured the loan, the lender will accelerate the loan, meaning you must pay off the loan immediately; otherwise the lender may foreclose.

In a judicial foreclosure, which many states require, the lender must go to court for approval. A judicial foreclosure can take from 18 months to as long as 3 years.

In a state that allows deeds of trust rather than mortgages, a foreclosure can proceed in a matter of months, because the lender simply notifies the trustee named in the deed of your default. The trustee (not a bankruptcy trustee) will send you some notices, but if the default is not cured, the trustee sells the property, and pays the lender its due amount. This process generally requires the trustee to record a notice of default at the county courthouse, to advertise about the impending auction of the property with the amount due, to hold the auction, then to record a copy of the sale, or an affidavit of foreclosure.

When the property is sold, the lender is paid, and whatever is left is paid to you.

If the sale of the home does not pay off the loan, then the lender can obtain a deficiency judgment, which is an unsecured judgment that will allow the lender to go after other assets to pay off the loan. However, if you live in a state, such as California or Arizona, where mortgages are nonrecourse loans, then the lender cannot sue for a deficiency. Indeed, during the real estate bubble burst that occurred in 2008 - 2010, many homeowners in these states simply walked away from their mortgages because their homes were worth less than the mortgage balance, which is known as a strategic default.

During the period of default, but before foreclosure actually occurs, most states give the borrower an equitable right of redemption, which allows a homeowner to reinstate the loan by paying all arrearages plus costs. Some states also give a statutory right of redemption to the borrower, whereby the borrower can redeem the property, up to 1 year after the sale, by paying the amount of the loan to the court, which holds the property in receivership during the redemption period.

Foreclosure in a Chapter 7 Bankruptcy

Chapter 7 bankruptcy does not prevent foreclosure. When you file for bankruptcy, the automatic stay takes effect, and temporarily prevents the lender from proceeding with the foreclosure. However, the lender will ask the court to lift the automatic stay, which will usually be granted, allowing the foreclosure to proceed.

If you have little or no equity in your home, losing it in a foreclosure will not have a big financial impact, and, indeed, the best option may be to just walk away from it.

If you have nonexempt equity in your home, then the bankruptcy trustee will probably oppose the foreclosure in court, so that the trustee can sell it to pay creditors. In this case, the lender will be paid in full, you will get your exemption amount, then junior lienholders of the property will get paid, and the rest, after deducting the trustee's commission, will be used to pay unsecured creditors. It will usually be better for the trustee to sell the property, because the trustee is paid a commission of what she can pay unsecured creditors, and, thus, will seek the highest price for the home, whereas the lender will mainly be concerned about getting the loan repaid.

If you do have equity that is not exempt, then the main benefit of a Chapter 7 bankruptcy in a judicial foreclosure is that it may give you enough time to either sell the home, or redeem it. A Chapter 7 bankruptcy lasts 4 to 6 months, so most of the your debts will be discharged, giving you more disposable income that can be applied toward a possible redemption of the property, to refinance the loan, or to sell it, especially in a hot real estate market.

A Chapter 7 discharge will also help you to negotiate with the lender to spread out missed payments, or refinance. A lender is more likely to renegotiate if you seem likely to be able to follow through on the renegotiated deal, especially with your other debts discharged.

Because a nonjudicial foreclosure is completed quickly, Chapter 7 will probably not be beneficial.

Prevent Foreclosure by Filing Chapter 13, 12, or 11

You can prevent foreclosure by filing Chapter 13, but you must pass the means test, which requires having enough disposable income to pay all priority and secured debts, and to pay at least 25% of your unsecured debt or the value of your nonexempt property, whichever is greater, over a 5 year period. If you cannot do this, the judge will probably not approve your repayment plan, and you will have no choice but to file under Chapter 7, or simply dismiss your case.

If you do not have enough disposable income to fund your repayment plan, you may be able to use the equity of your home to refinance and use the money to help pay for your repayment plan.

Your plan must be approved by the judge, and you must have the money at that time, or soon afterward.

Like Chapter 13, but with higher debt limits, Chapter 12 can allow family farmers or family fishermen to prevent foreclosure on their homestead and their business property.

Chapter 11 is also available to debtors with debts larger than those allowed for Chapter 13, and can prevent foreclosure with the approval of a repayment plan.