When should you use Chapter 13 bankruptcy to stop foreclosure?

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In a Nutshell

Filing for Chapter 13 bankruptcy has the potential to provide short- and long-term help for people facing foreclosure of their homes. But it’s a complicated process full of restrictions as well as serious consequences for your credit profile. If you’re considering taking this path, we advise speaking to a qualified expert for advice specific to your needs.
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Foreclosure can be one of the scariest prospects a homeowner may face. Just the possibility can send homeowners looking for any way to save their homes.

Bankruptcy is often seen as a last resort for people in heavy debt beyond their means, and certain portions of the bankruptcy code can look like lifelines to homeowners hoping to avoid the painful process of foreclosure. While the purpose of Chapter 7 is to provide a way for people to sell their assets to get out from under debt, Chapter 13 bankruptcy is designed as a pathway to keep your property for the long term by way of a repayment plan.

So it’s important to know that bankruptcy is anything but a quick fix — it’s a serious process full of complicated legal requirements and eligibility standards, long-lasting negative consequences for credit profiles, and potential multiyear commitments to paying off debts falling under the filing.

If you’re considering using bankruptcy to help keep your home, then you should have a clear sense of what you’re getting into before filing. In this article, we’ll run down some of the key ways to stay in your home through bankruptcy and a few reasons you may not want to put yourself through the process.

Keeping your house in Chapter 13 bankruptcy

Bankruptcy can bring up visions of lost assets, including a “SOLD” sign plastered on your beloved home. Under the provisions of Chapter 13 bankruptcy though, this fear doesn’t have to come true.

Chapter 13, commonly referred to as the “wage earner’s plan,” can be a wise choice for people who find themselves under a mountain of debt but still have steady income. Unlike Chapter 7 bankruptcy, in which eligible assets can be sold off to settle debt, Chapter 13 allows debtors to propose a repayment plan — typically three to five years — depending on income level. If debtors follow the plan and all conditions are met, they receive a discharge of the debts included in the plan.

Crucially, a Chapter 13 bankruptcy could also end with the debtor’s homeownership intact.

The repayment plan can incorporate missed mortgage payments, allowing homeowners to become current with their lender. However, the plan does not release the debtor from the established mortgage payment schedule — the debtor must still make those monthly payments during the repayment plan.

Bankruptcy’s ‘automatic stay’ provision

Regardless of your ability to obtain a discharge through Chapter 13 bankruptcy, filing presses the pause button on the foreclosure process via the “automatic stay” provision. This protection generally allows the debtor a break from persistent communication and collection efforts from most creditors, including mortgage lenders. The foreclosure process won’t stop completely, but the automatic stay will create a little breathing room until a repayment plan is scheduled and accepted by the court.

But the key phrase there is “a little breathing room” — the automatic stay provision is not a fail-safe to keeping your home. For one thing, it can’t reverse portions of the foreclosure process that have already been completed. If the mortgage lender has completed the foreclosure sale prior to the bankruptcy being filed, then the house can still go into foreclosure auction.

The automatic stay also doesn’t protect you from the consequences of missing new mortgage payments during the Chapter 13 repayment period. If those payments are missed, then the lender can petition to proceed with the foreclosure process.

The automatic stay provision in Chapter 7 bankruptcy

The automatic stay can also provide some relief in a Chapter 7 bankruptcy, although it may not allow you to stay in your home after the bankruptcy. In Chapter 7, the debtor’s eligible assets are sold in order to pay back creditors. A house is likely to be included in that sale if it’s worth enough to cover eligible debts, but the automatic stay could provide the opportunity to remain in your home until that time — allowing you the chance to make other living arrangements during this monthslong bankruptcy process.

The long-term effects of Chapter 13 bankruptcy on credit

While these Chapter 13 bankruptcy provisions can provide help to some people staring down foreclosure, they are anything but a simple solution to the problem. Any bankruptcy carries major risks and long-term consequences. Even a successful bankruptcy will have lingering effects.

One of the most measurable and immediate effects to consider is what bankruptcy does to credit scores. In most cases, a Chapter 13 bankruptcy stays on your credit reports for seven years (three years less than a Chapter 7 bankruptcy) and is considered an especially negative event for most credit-scoring models.

Lenders will ultimately consider more than just scores when assessing whether to approve a potential borrower, but a major derogatory mark like a bankruptcy can affect your ability to obtain new credit cards, loans, and the kinds of interest rates and other terms you’ll get on those products. That includes any mortgages (including refinances) you hope to get in the future.

Lenders could be hesitant to approve long-term, high-dollar loans and could choose to decline such applications. Even if the application is approved, you can expect the loan to be at a very high interest rate and require a higher down payment and higher closing costs than would have been otherwise. With a bankruptcy on your record, you’re more likely to be identified as a high-risk borrower.

On the other hand, a foreclosure also has a negative impact on credit. It will also stay on your report for seven years, and its effect on scores is often only slightly less negative than that of a bankruptcy. That means you could experience similar trouble finding new loans and getting favorable terms when you do.

Bottom line

Both the effects and value of a bankruptcy or foreclosure depend heavily on individual circumstances, so we suggest you speak with a qualified financial adviser or bankruptcy lawyer before making any decisions about the best path for you. These professionals should be able to assess your unique situation and provide the most-appropriate advice.

Even before speaking with an expert though, it’s probably worth considering just how important it is to you to hold onto your home. Neither a foreclosure nor a bankruptcy is a great option, but the best option for you could hinge on your ultimate goal.

If you can’t imagine leaving your home, then your options may be limited. But a willingness to live elsewhere could open up a few other paths, including filing for Chapter 7 bankruptcy or accepting foreclosure.

About the author: Sarah Schaut is a Canadian living in sunny Florida. She’s an economic crimes detective at a city police department and an expert in credit, fraud and mortgages. Read more.