What Happens to My Upside-Down Mortgage in Bankruptcy?

A bankruptcy case might help get rid of a junior mortgage or eliminate the risk of a deficiency balance after a foreclosure.

Some people looking to get out from under an upside-down mortgage are content to turn the property over to the mortgage company. If you'd rather keep the house, filing a bankruptcy case might give you the tools to make the mortgage easier to justify while you're waiting for the value to increase.

What Are the Options?

At any time during a bankruptcy case, you can surrender your house to the bank. By doing so, once you complete your Chapter 7 or Chapter 13 case, your responsibility to pay the debt will get wiped out (discharged). All other options available for an underwater property will depend on the bankruptcy chapter that you file.

Chapter 7 Bankruptcy

If you want to keep your house after you file for bankruptcy, you will have to continue making payments on it because even though your responsibility to pay the debt will get wiped out, any and all liens secured by the property (including the mortgage liens) will not go away. Therefore, any lender with a security interest in the property will still have the right to foreclose on the property.

Some people believe that it isn’t important to pay on a junior lien when the value of a house is less than the amount that a foreclosing lender could sell it for. The thought is that the junior mortgage won’t foreclose because, after the first mortgage gets paid, there won’t be anything left for a lender in the second or third position.

However, as a practical matter, it’s important to continue to make payments on any junior mortgages—even you’re not in jeopardy of a junior lender foreclosing anytime soon due to the house being underwater. Since the lien won’t go away, as property values rise, so will the likelihood that a junior lienholder will seek payment by foreclosing on the house.

Also, you should be aware that if you’re behind on your payments, Chapter 7 bankruptcy doesn’t provide a mechanism to help you catch up. Although it’s possible that you’ll be able to modify the loan or renegotiate the terms, you’ll have to accomplish that outside of the bankruptcy itself (and you shouldn’t assume that it’s likely to happen).

Reaffirming a Mortgage Loan in Chapter 7 Bankruptcy

In a Chapter 7 matter, your lender might allow you "reaffirm" the debt (this usually occurs under the original terms, although the parties can renegotiate). Reaffirming a debt is, in essence, entering into a new contract. If you do so, the debt won’t get discharged (and, as discussed above, the lien will remain, as well). You’ll continue to be responsible for it until it’s paid off.

If you later find yourself in financial trouble and can’t make the payments, the mortgage company will foreclose. In some states, you’ll find yourself responsible for any deficiency balance (the amount still outstanding after the foreclosure sale). And, even if the lender forgives the deficiency amount, you’ll likely have to pay income tax on it.

Not reaffirming the debt comes with its own set of problems. The mortgage creditor probably won’t attempt to foreclose as long as you’re current on your payments. However, fearing that it will run afoul of the bankruptcy discharge, you might find that your lender won’t do the following:

  • send you a monthly statement
  • allow you to make electronic or credit card payments
  • report payments to credit bureaus
  • consider an application for a loan modification
  • consider a short sale or take a deed in lieu of foreclosure, or
  • talk with you when you have payment or title issues.

Given the long-term ramifications of any choice you make, it’s prudent to consult with a knowledgeable bankruptcy attorney.

Chapter 13 Bankruptcy

You’ll have more options under Chapter 13 bankruptcy.

Catch up past due mortgage payments. If you’re behind on your mortgage payments, you can use a Chapter 13 repayment plan to bring them current. You’ll make your regular monthly payment. Additionally, you’ll pay off the arrearage as a part of your 36- to 60-month repayment plan. You’ll have to demonstrate to the court that you have enough income to complete your plan.

Strip off junior mortgages. Some properties are so underwater that the value isn’t enough to pay off the first mortgage, much less a second or third mortgage. If your house is this upside down, you may be able to strip off the second and third mortgages. For instance, suppose that your house was worth $250,000 when you bought it but it’s only worth $200,000 now. Your mortgage to First Bank has a balance of $210,000. You also have a mortgage to Second Bank with a balance of $25,000. If First Bank were to foreclose, the property would not bring enough in a sale to cover the balance of the First Bank mortgage. That would make Second Bank’s lien worthless. You can strip off that lien in a Chapter 13 case (this option isn’t available in a Chapter 7 bankruptcy).

Cramdown a mortgage on a vacation or investment home. The “cramdown” option isn’t available for a residence, and it’s costly, so it’s rarely used. However, if you can swing it, it allows you to offer to pay the lender just the property value and potentially reduce a high-interest rate. However, you must pay off the full property value within 60 months (which isn’t something that most people can accomplish).

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