Homeowners’ stark choice in Chapter 7

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Dear Bankruptcy Adviser,
My husband and I have filed for Chapter 7 bankruptcy. We have a first mortgage which is $301,000; we are current on this. We have a second mortgage for $100,000. Our house’s fair market value falls to around $294,000. We were approved for a modification on the second mortgage, and then they rescinded the approval because we filed for bankruptcy. So I have not paid it in three months. Can they try to foreclose on my house?
— Lori

Dear Lori,
Your situation is all too common right now. It appears that you filed for bankruptcy on your own because had you been my client, I would have had you complete the modification and then file for bankruptcy.

The problem is that many lenders are apprehensive about working with a borrower once he or she has filed for bankruptcy. Some lenders will not send monthly statements while a homeowner is under bankruptcy protection. Others go so far as to never again send statements even after the bankruptcy is over.

The reason is that most lenders have been sued so many times for bankruptcy law violations that the general strategy is, doing nothing is better than doing something. This approach is frustrating to borrowers, but we did this to ourselves.

While lenders are at times culpable for being heartless, soulless machines, you can’t blame them for not wanting to be sued. As a result, everyone gets shut out.

Here is some good news. If your mortgage is upside down, meaning you owe more than the house is worth, the second mortgage lender is unlikely to foreclose because it would have to pay off the first mortgage. And in your case, that would leave nothing to pay the second lender’s loan.

To illustrate, let’s say you owe $300,000 on your first mortgage and $50,000 on the second. Yet your property is worth only $200,000. If the second mortgage lender foreclosed on the property, it would have to pay the first mortgage lender prior to getting any money. In this example, the second mortgage lender would get nothing. So it has little incentive to foreclose on your home. Keep the first mortgage current, and I am confident that the second mortgage lender will work with you.

Of course, in today’s environment, things are getting a bit dicey. The second mortgage lender may require you to sign a “reaffirmation agreement” while inside the bankruptcy before modifying your loan post-filing. This is an agreement by a Chapter 7 debtor to the terms and conditions of a contract that otherwise would have been eliminated in the bankruptcy proceeding. Many debtors decide to reaffirm their house and cars, thus continuing with payments while keeping the property.

I never advise a client to reaffirm a mortgage loan. While the bankruptcy does not wipe out the lien against your property created by the loan, it does wipe out your liability to pay on that debt if you decide to walk away from the house.

In California, it is typically safe to reaffirm the first mortgage, though even that comes with some risks. But each state is different. In other states, if the first mortgage lender forecloses and sells the property for less than the balance owed, the lender can come after you for the difference.

Even more disturbing, second mortgage lenders are telling clients that without a court-approved reaffirmation agreement, they will not modify loans after a bankruptcy.

This sets up an all-or-nothing proposition. If you file for bankruptcy but want to keep your home, you may need to re-establish the loan terms and therefore the loan liability. The alternative is walking away from the house.

Either way, the quandary may result in more sleepless nights.

Read more Bankruptcy Adviser columns and more stories about debt management.