How to Use Chapter 13 to Avoid Foreclosure
This article explains how an individual can use the Bankruptcy Code to help save their home from foreclosure. To understand how this works you need to know a little bit about chapter 13 bankruptcy and its treatment of home mortgages under a debtor’s chapter 13 plan.
The Automatic Stay
When a debtor files bankruptcy – regardless of which chapter a debtor files under – the bankruptcy filing automatically and instantly creates a stay against all collection proceedings against the debtor and his/her property. The stay is created without any additional action taken by the debtor. Although creditors need to be notified of the bankruptcy filing, any action taken by a creditor – either as collection against the debtor or the debtor’s property – is considered void, regardless of whether the creditor had notice of the bankruptcy filing.
If a mortgage lender has commenced foreclosure proceedings against a debtor’s home, the automatic stay instantly bars the mortgage lender from continuing the foreclosure process.
Here’s an example: a debtor has been trying to do a loan modification with her lender to no avail. The lender has commenced the foreclosure process by recording a notice of trustee sale, and pursuant to that notice, has scheduled a trustee sale for January 1 at 9:00 a.m. The debtor, after having exhausted other options to save her home, files a bankruptcy petition on January 1 at 8:59 a.m. The lender proceeds with the foreclosure as scheduled. The result here, is that since the automatic stay was triggered at 8:59, the foreclosure is void as if it never legally took place title to the property remains in the debtor’s name. The debtor is now given a breathing spell to present a chapter 13 plan to get caught up on payments.
Treatment of Home Mortgages in a Chapter 13
In a prior blog post and podcast, I discussed cram downs under a chapter 13. Again, a cram down is any modification of a creditor’s lien under chapter 13. Cram downs are generally not allowed as it relates to home mortgages because the bankruptcy code provides that chapter 13 debtors cannot modify claims secured by a debtor’s principal residence.
So, what can a debtor do with its home mortgage in a chapter 13?
Although the bankruptcy code doesn’t allow debtors to modify home mortgages, it does allow the debtor facing foreclosure to save the debtor’s home by making regular monthly payments plus monthly “cure” or “catch up” payments to cure mortgage arrears over the life of the plan. (often 60 months) Here’s an example: a debtor’s lender commenced the foreclosure process when the debtor fell behind 3 monthly payments totaling $6,000. The monthly payment obligation is $2,000. The debtor can save her home in a chapter 13 if her chapter 13 plan proposes to pay this creditor monthly payments of $2,100 (reg. monthly payment of $2,000 plus $100 monthly catch-up payment).
For debtors who cannot come up with the cash in one lump sum to come current and prevent foreclosure chapter 13 is a highly effective tool.
Strip Off of Junior Liens
Another option for underwater homeowners could be a strip off of a wholly unsecured lien. What is this? Recall that the bankruptcy code provision precluding modification of home mortgages uses the language “secured by a debtor’s principal residence.” Under a strip off, a junior lien that has no equity for its lien position (i.e., wholly unsecured) can be treated in its entirety as an unsecured claim and in effect, “stripped off” the debtor’s home so that it is wiped out entirely. This is because, according to section 506(a) of the bankruptcy code, a claim is only secured to the extent there is equity in the asset it encumbers. Therefore, if the first position mortgage lender’s lien amount exceeds the value of the home, the junior lienholder would have no equity for its lien position and as a result, be wholly unsecured. Chapter 13 only bars modification of “claims secured by a debtor’s principal residence”. So, if a junior lien is unsecured, accordingly to bankruptcy courts interpreting this provision, the debtor may treat it as unsecured under the plan and it may be stripped off entirely.