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Underwater On Your Home Option 6: Bankruptcy

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This is the final installment of my six-part series on possible ways to deal with an “underwater” home.

Option #6: Bankruptcy

If you are drowning with an underwater mortgage, bankruptcy may help you get your head above the water – but it doesn’t always put you back on solid ground. “Bankruptcy by and large doesn’t solve the discrepancy between value (of the home) and debt. As long as it’s your home, the bankruptcy code prohibits the court from conforming the balance of the mortgage to the value of the home” warns Cathy Moran, a California-based consumer bankruptcy attorney. “That wasn’t always the case, but it has been for a long time and the efforts to change that died in Congress two years ago.”

What Moran is describing is the fact that mortgages on primary residences can’t be “crammed down,” or modified in bankruptcy so that the balance is in line with the value of the home.

Still, there are several ways that bankruptcy can help if your home is worth more than you owe:

  • If you are behind on your home, a Chapter 13 can help you catch up on payments over five years without interest, “but that’s a remedy that’s independent of whether you are underwater,” notes Moran.
  • A bankruptcy may halt a foreclosure long enough to get a loan modification considered. “And if the lender is willing to modify the terms you may be able to stay in the property by reason of the loan modification,” Moran says.
  • Your home equity loan may be “stripped off.” If the value of your home is less than that of the first mortgage, then the second mortgage or home equity loan is essentially an unsecured loan that may be discharged in bankruptcy.
  • You may be able to reduce or eliminate other debts, freeing up more money to pay toward the home mortgage so you can get back to positive equity more quickly.
  • A deficiency judgment resulting from a short sale or foreclosure may be dischargeable.

Debts discharged in bankruptcy are not taxable the way other forgiven debt may be, but the timing here can be tricky. If you may owe taxes on forgiven debt resulting from a mortgage foreclosure or short sale, it’s vital that you talk with a bankruptcy attorney before the foreclosure or short sale is completed.

Chapter 7 bankruptcy (straight bankruptcy) remains on your credit reports for ten years from the date you file. Chapter 13 bankruptcies are removed seven years from the filing date. Bankruptcy has a significant impact on your credit scores, but so does foreclosure.

Other options for homeowners with “underwater” mortgages:

  1. Underwater On Your Home Option 1: Stay and Pay
  2. Underwater On Your Home Option 2: Refinance
  3. Underwater On Your Home Option 3: Get a Loan Modification
  4. Underwater On Your Home Option 4: Short Sale
  5. Underwater On Your Home Option 5: Walk Away / Foreclosure
  6. Underwater On Your Home Option 6: Bankruptcy

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  • TR

    Recently filed and awarded for Ch.7 bankruptcy- owed more than the home was worth with a 10% interest rate- mortgage payment did not include taxes either- $3500 on $376,000 was extreme- no one would refi, mod or talk- bankruptcy was the only option.What also needs to be addressed is- asking if your plan is to stay in this home for the next 20yrs- I believe recovery is coming within the next 8yrs, but do I see myself living in this home for that long? Bankruptcy gets a bad rap- I know its not an easy fix but for some, like myself, its the only option.

    • Gerri Detweiler

      Thanks for sharing this TR. I am sure it wasn’t an easy decision, but it sounds like you made the best decision possible for your financial future.

  • Matt Sizzer

    Hello I have a question. I am in the middle of a Bankruptcy I was told that the interest rate couldn’t be adjusted when doing a chapter 13 or 7. Does Fannie may allow rate adjustment on their mortgages while in Modification / bankruptcy court? Who can I call to find the answer thank you.

    • Credit.com

      Matt – We’d love to help but in this case, this is a question for your bankruptcy attorney. Hopefully you are working with one.

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