My Borrower Filed for Bankruptcy—Now What?
Suppose you are notified that your borrower has filed for bankruptcy. By law, all lenders the debtor owes funds to must be notified of a bankruptcy action. What does this mean for you? It depends largely on the type of bankruptcy and your legal status as a lender. The most common consumer bankruptcies are Chapter 7 and Chapter 13.
Chapter 7
This type of bankruptcy is oftentimes referred to as a “liquidation” plan. In a Chapter 7, the bankruptcy trustee cancels or forgives most—or sometimes all—of the borrower’s debts. The trustee may also sell any assets the borrower has to repay creditors. The entire process usually takes five to seven months to complete. When completed successfully, it is referred to as “discharged.” This is, in essence, a fresh start for the borrower.
If for some reason a Chapter 7 is not completed successfully, it is referred to as “dismissed.” Being dismissed basically treats the bankruptcy proceeding like it never happened, therefore the borrower still owes all his/her debts. A dismissal can happen for a number of reasons, some of which have to do with the borrower not being able or willing to comply with the trustee requirements.
In a successfully discharged Chapter 7 bankruptcy, many creditors lose their claims. This means the borrower is no longer personally liable for the debts, and the lender can no longer pursue or contact the borrower for payment. This happens frequently with unsecured debt.
Unsecured debt includes things like credit cards, consumer loans, cellphone and cable bills, and other accounts that are not attached to collateral via a note. Items that are secured by a note, such as houses, property, and even car loans, are not forgiven. With these, the borrower has the choice to do one of the following:
- Voluntarily surrender the items back to the lender.
- Reaffirm the debt and continue making payments.
What Happens to a House in Chapter 7 Bankruptcy?
In Chapter 7, borrowers do not automatically lose the home. They can choose to retain the home and continue making mortgage payments. They can also sign an agreement called a “reaffirmation agreement.” This is essentially the borrower recommitting to the terms of the loan and promising to pay it. Since a note and mortgage are secured and attached to the property, it is not usually wiped away or made noncollectable in Chapter 7 filings.
However, there is some nuance to this. When a Chapter 7 is discharged, the borrower no longer owes the money personally for the note and mortgage. The property owes the money. This may sound a little strange, but the borrower has been forgiven of the personal liability for most of his debts. This includes a note and mortgage. That means you cannot pursue a judgment or sue the borrower personally for this debt—but his home still owes the debt outlined by the note and mortgage. With this protection in place, the noteholder still retains all rights to foreclose and sell the property if the note goes into default. So while this may seem a little strange, it is actually a great thing for a note holder.
Why do I say this is a great thing? Well, let’s think about it. After successfully completing a Chapter 7, the borrower is free of the crippling consumer debt that was draining his bank account each month.
With these gone, he will have more money to pay his mortgage. My experience has been that most people will choose to retain their home both during and after bankruptcy.
If they don’t, you can simply exercise your right as a lender and foreclose, then dispose of the home to recover your money. I think you will find completing a foreclosure is a rare occurrence, and in most cases a headache, but not a huge cause for concern.
For further information on bankruptcy:
http://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics
http://www.nolo.com/legal-encyclopedia/bankruptcy
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(This article is an excerpt from Joshua N. Andrews Book titled Paper Profits – How to Buy and Profit from Notes a Beginners Guide)
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