While not as hard hit as Florida or California, Colorado was not unaffected by the bursting of the housing bubble in 2007 and 2008. As we approach the tenth anniversary of the greatest American financial crisis since the Great Depression, some Coloradans are still picking up the pieces.
Many homeowners who sought a fresh start under the Bankruptcy Code are surprised to learn that the means test created by the 2005 amendments to the Code meant they could no longer file a Chapter 7 liquidation bankruptcy.
Others with limited income and remain eligible to file Chapter 7 petitions. When we get calls from these prospective Chapter 7 filers, their most common questions relate to keeping possession of their homes and cars.
Although we’ve discussed this issue in both our FAQs and our bankruptcy guide for individuals, “Everything You Wanted To Know About Bankruptcy But Were Afraid To Ask” (available through this website) the topic is important to so many people that it’s worth reviewing in this post.
Can I Stay in My Home?
This is naturally the question that is front of mind with most prospective Chapter 7 filers. The answer depends on three things:
‒ The value of the home.
‒ Whether mortgage payments are current.
‒ Whether you are able and willing continue making those payments.
A lender is more likely to foreclose if it believes the sale price will repay all or a meaningful portion of the loan. As such, a homeowner whose property has lost value may actually be at less risk of losing his home.
But many callers are still unclear as to why they must keep making mortgage payments. They appear to believe that the mortgage lien was somehow eliminated by their discharge. We therefore emphasize to all potential Chapter 7 filers that this is incorrect. In fact, a Chapter 7 discharge eliminates only the borrower’s personal liability for the loan. The lender keeps its mortgage lien and if the loan is (or later becomes) delinquent, it can foreclose ‒ that is, it can force the sale of the home to repay the debt.
By comparison, in Chapter 13 bankruptcy, the mortgage debt is not discharged. However, Chapter 13 allows the debtor to catch up on delinquent mortgage payments over time, while a Chapter 7 filer has no such rights. This is why the status of the mortgage loan and the debtor’s ability to continue making payments are critical factors.
What About My Home Equity Loan?
When home values were rising, many took advantage by obtaining a home equity loan or line of credit.
Historically, home equity lenders would typically lend the difference between a homeowner’s first mortgage balance and 80-85% of the home’s value, leaving 15-20% in an equity cushion. In mortgage-speak, this is referred to as a combined loan-to-value ratio (CLTV) of 80-85%.
As reckless as it may seem in hindsight, some lenders were so certain that home values would continue to rise that they made second lien mortgages that resulted in CLTVs of 100% or even 110%. Of course, when the bubble burst many of these folks were left with homes worth less than the balance on their first mortgage.
In these cases, the home equity lender is left with what is in practical terms a worthless lien. Nevertheless, as with a first mortgage, the home equity lien also remains valid even after a Chapter 7 discharge. The equity lender may therefore choose to foreclose if the equity loan or line of credit is in default and it believes it can recover some of its money through a sale of the home. It may also elect to leave the lien in place, knowing that it must be satisfied if the home is sold or the first mortgage is refinanced.
Chapter 13 Bankruptcy as a Possible Alternative
Some prospective Chapter 7 filers ask us about something called “lien stripping” in bankruptcy. As the name suggests, lien stripping is a process by which the bankruptcy court invalidates a junior lien on an asset when there is no equity; that is, where the balance owed to the senior lienholder is greater than the asset’s value.
Seems as though this should be an option with mortgage loans, right? Unfortunately, it’s not that simple. First, the Bankruptcy Code does not permit the court to strip an otherwise valid home equity lien under any circumstances in a Chapter 7 case.
This question comes up more frequently by people who have filed Chapter 7 in the past and thought their second mortgage was discharged. While technically correct, the lien for the second mortgage still exists, but only when they try to sell or refinance their home do they discover this. That’s when they call us to find out if there’s any way to get rid of the lien. Again, the answer is no. The only way to get rid of the lien is by paying off the underlying loan.
In a Chapter 13 case, lien stripping is possible in some cases. Subject to some complex exceptions, however, this is not true if the only collateral for the home equity loan is a lien on the borrower’s residence.
The Need for Sound Legal Advice
Many prospective Chapter 7 filers don’t know that they can elect to file instead under Chapter 13. Each person’s situation is unique, and the guidance of an experienced bankruptcy attorney is invaluable in making the best choice.
You can schedule a free consultation by clicking here.