Bankruptcy

Does Chapter 7 Bankruptcy Discharge a Secured Mortgage Loan?

Although Chapter 7 bankruptcy will wipe out your mortgage, you'll still have to pay it if you want to keep your house.

Chapter 7 bankruptcy won’t help you keep your home free and clear of any payment. What it will do is discharge (wipe out) a mortgage loan secured by property, but in exchange, you’ll have to give your residential house back to the lender. If you want to keep your home, you must continue paying for it.

What Is a Secured Loan?

A borrower who enters into a secured loan contract does more than agree to pay back the borrowed funds. The borrower puts up property, or collateral, to ensure payment of the loan. The voluntary agreement to collateralize the loan creates a lien that allows the lender can take the property if the borrower fails to follow the contract terms.

One of the most common types of secured loans is a mortgage loan. A homeowner who fails to make a house payment risks the lender seizing the house through foreclosure and selling it at a foreclosure sale. The bank uses the auction proceeds to pay down the mortgage debt.

Another commonly secured loan is the car loan. The lender can take the vehicle through repossession if the borrower falls behind on the car payment. Like a home, the car gets sold at auction and the proceeds go toward the loan balance.

In both cases, the auction funds might not pay off the loan completely. The outstanding balance is called a “deficiency balance.” Most states hold the borrower responsible for a deficiency balance on a vehicle loan. Not all states, however, will allow a lender to pursue the deficiency balance on a home loan (although most states allow for it).

(For more information, read What Are the Differences Between Secured and Unsecured Debt?)

How Does Chapter 7 Bankruptcy Work?

Most individuals choose between two types of bankruptcy: Chapter 7 or Chapter 13 bankruptcy. If you file Chapter 7 bankruptcy and you want to keep your house, you must be current on your payment when you file and continue to make payments to the lender after the bankruptcy case closes. Here’s why.

In a Chapter 7 bankruptcy, a debtor (the person who owes the debts) can keep a certain amount of property, called exempt property. Exempt property usually includes furnishings, clothing, an inexpensive car, certain retirement accounts, and some equity in a home. The state decides what a debtor can protect. Nonexempt property gets sold, with the funds divided among the creditors. In return, debtors get a “discharge,” a court order barring creditors from collecting on any of the debts included in the bankruptcy case.

Chapter 7 bankruptcy discharges your liability (responsibility to pay) on a mortgage loan. It doesn’t remove the lien against the home, however, and it’s the lien that gives the bank the legal ability to take back the house if you fail to pay for it according to the contract terms.

If Chapter 7 bankruptcy removed the lien, all anyone would have to do to get his or her house free and clear would be to file a Chapter 7 bankruptcy—but it doesn’t work this way. So you must continue to pay your mortgage if you wish to keep the house, car, or any other property that you’ve pledged as collateral. If you don’t pay the mortgage amount, the lender can use the lien right to foreclose and sell the house at auction to recover its losses.

It’s important to note that if you’re caught up on your mortgage payments when you file for Chapter 7 bankruptcy, and you continue to make the payments after your bankruptcy, you’ll likely be able to keep your house. (Due to jurisdictional differences, you should verify this with a local bankruptcy attorney).

Chapter 7 bankruptcy doesn’t provide a way to catch up on mortgage payments, however. So if you’re behind, you’ll likely lose the property (although some lenders might consider working with you, you shouldn’t count on it). If you’ve claimed exempt equity, the exemption amount must be returned to you before any creditors (other than the lender) receive any funds.

Keeping Your House Using Chapter 13 Bankruptcy

If you’re behind on your payment and want to stay in the house, you’ll have to bring the house payment current. Chapter 13 bankruptcy is set up to help debtors do that very thing.

In Chapter 13 bankruptcy, you’ll propose a payment plan that will allow you to get caught up on missed mortgage payments over time. You’ll have to show that you have enough income to make your regular monthly payment, your monthly bills, and catch up on the arrearages (you’ll spread them out over three to five years).

Chapter 13 bankruptcy also has some different rules from Chapter 7 bankruptcy. One of these rules allows a debtor to remove a second, third, or greater mortgage lien (potentially any lien other than the lien in the first position) from the property. The debtor must show that the property value has declined to the point where the lien is unsecured (there isn’t enough money to pay even one dollar to the junior mortgage to be removed). This action cannot be used in a Chapter 7 case. If you keep your home in Chapter 7 bankruptcy, all liens remain in place.

Speak With an Attorney

If you want to keep your home, or if it has equity in it (it would sell for more money than you owe), you should consider speaking with a local bankruptcy attorney. Not only will you learn about your options (and you might have more than you realize), but the first consultation is often free.

Questions for Your Attorney

  • Can I keep my house if I file for Chapter 7 bankruptcy?
  • Which chapter should I file if I’ve missed two mortgage payments?
  • How can I find out what my home is worth?
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