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Foreclosure 101

In this guide we provide an overview of what foreclosure is, what causes foreclosure, the impact of foreclosure on owners and renters, and an introduction to the opportunities foreclosure presents to real estate professionals.

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Foreclosure-FAQ11

 

Why Foreclosure Happens

A great many things have been blamed for causing foreclosures. Having purchased more than 150 foreclosures, talked with hundreds of owners in foreclosure, and having read every study I come across on the subject, there seem to be just a couple of root causes: declining prices, which leave homeowners with negative equity and unable to sell, and certain life events like death or divorce which can cause foreclosures in even the best housing markets. We’ll look briefly at each below.
Negative Equity

There is strong evidence to suggest that negative equity, meaning that an owner owes more on their loans than the house is worth, is the leading cause of foreclosure. As lenders rarely loan more on a property than it is worth, this primarily occurs after prices drop.
Why is having negative equity, also referred to as being underwater, such an important factor? Because homeowners with equity have options—they can refinance or sell if they run into trouble making their payment. Underwater homeowners lack these options, leaving foreclosure as the only way out, unless the lender is willing to take less then they are owed in a short sale, or modify the loan terms.
Typically, the leading cause of price declines is economic downturn. While this is still the primary issue in certain parts of the country which are losing jobs or entire industries; the housing bubble that occurred from 2000-2007 has led to wide scale price declines, after prices reached unsupportable levels using risky loans. These loans put buyers in homes they could not otherwise afford. As these loan offerings were removed from the market, prices were forced to return to levels that buyers could afford, using more traditional financing. This caused prices to drop by 50% or more in the hardest hit areas. As prices declined, foreclosures rose.

Five D’s of Foreclosure

Despite the fact that the vast majority of foreclosures are driven by negative equity from price declines, there is a base rate of foreclosure that happens during even the best economic times and housing markets. This base rate can largely be explained by the Five D’s of Foreclosure:

Death—The passing of a head of household can very quickly result in foreclosure.

Divorce—Even in the most amicable of divorces, spousal support and house payments are missed. More common is one refusing to leave, and the other refusing to pay.

Drugs—Drug use and abuse impairs judgment, and fixes become a higher priority than house payments.

Disease—Catastrophic illness, chronic disease, lack of health insurance coverage, or a primary provider falling ill; any of these can significantly impact a homeowner’s ability to make mortgage payments.

Denial—A home is a person’s castle, their security. Individuals often refuse to acknowledge that their home can actually be taken from them, if they fail to meet their financial obligations.

What about Subprime?

Despite many blaming defaulting subprime loans for the latest downturn, there is little evidence pointing to subprime foreclosures as the primary cause. For example, a study done by the Boston Fed looked at various factors, including credit score, income, job loss and other factors typically blamed for foreclosure; and found that while these factors contributed, foreclosure was unlikely unless there had also been price declines leading to negative equity. It makes sense—if a house is worth more than is owed, it can be sold even if the person has bad credit or loses their job. Now, that’s not to say that loose lending standards did not play a role in this crisis. They did. Together with pay option ARMs, and other exotic loans, they clearly helped push prices too high, and thus ultimately led to the price declines that are at the root of the foreclosure crisis.

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Keep Your Home in Chapter 13 Bankruptcy

You can stop foreclosure and save your home in a Chapter 13 bankruptcy.

Chapter 13 bankruptcy provides opportunities for homeowners to delay or prevent foreclosure and pay off back debt on their mortgages. In some cases, homeowners can also eliminate the amount of second or third mortgages. Chapter 13 bankruptcy is particularly helpful to people who are behind in mortgage payments and need time to get current on their payments so they can keep their home indefinitely.

Saving Your Home

If you are behind on your mortgage payments, and cannot get current, Chapter 13 bankruptcy may be a good way to save your home. In Chapter 13 bankruptcy, you pay all or a portion of your debts over time through a repayment plan. Chapter 13 bankruptcy lets you pay off a mortgage “arrearage” (late, unpaid payments) over the length of the repayment plan — usually three or five years, depending on your income and the time it will take you to meet all the plan’s requirements.

In order for this option to work, you’ll need enough income to at least meet your current mortgage payment and your other basic expenses at the same time you’re paying off the mortgage arrearage. Assuming you make all the required payments up to the end of the repayment plan, you’ll avoid foreclosure and keep your home. (Note: Although Chapter 13 bankruptcy’s provisions can be used to prevent foreclosure in the long run, Chapter 7 bankruptcy provides a temporary relief from foreclosure that can sometimes lead to a long-term solution. To learn if you can use Chapter 7 bankruptcy to save your home, Your Home in Chapter 7 Bankruptcy.)

Eliminating Second and Third Mortgages

As mentioned, Chapter 13 bankruptcy may help you eliminate the payments on your second or third mortgage. That’s because if your first mortgage is secured by the entire value of your home (which is possible if the home has dropped in value), then you may no longer have any equity with which to secure the later mortgages. If this is the case, the bankruptcy court may “strip off” the second and third mortgages and re-categorize them as unsecured debt, which, under Chapter 13 bankruptcy, takes last priority. Unsecured debts are usually not paid in full in Chapter 13 bankruptcy and sometimes do not have to be paid back at all.

Halting or Delaying Foreclosure: The Automatic Stay

When you file a Chapter 13 bankruptcy petition, all foreclosure proceedings must stop (with one exception, discussed below) until your Chapter 13 repayment plan is approved by the court. This is called the “automatic stay.” If your repayment plan includes provisions for paying off your mortgage arrearage, then once the plan is confirmed (approved by the bankruptcy judge) the lender is bound by the plan and cannot continue with the foreclosure, assuming you make your regular mortgage and bankruptcy plan payments.

If your repayment plan does not include provisions to pay off your mortgage arrears, then once the court approves the repayment plan, the lender may continue with foreclosure proceedings. If you don’t want to keep your home as part of the Chapter 13 bankruptcy, filing for bankruptcy will give you a reprieve from foreclosure of at least several months, during which time you can continue to live in your home. In addition, since most bankruptcy judges give debtors several chances at proposing a feasible repayment plan, the confirmation process may take a long time — giving debtors an even longer respite from foreclosure. (However, if it appears that you’ll never propose a feasible repayment plan, the confirmation process can be greatly shortened.)

There is one exception to the automatic stay. If you have filed another bankruptcy petition within the previous two years, and that filing resulted in the automatic stay being lifted at the request of the party seeking a foreclosure, the filing of this Chapter 13 bankruptcy will not halt foreclosure proceedings. This is to prevent people from filing a series of bankruptcy petitions just to stall foreclosure.

Modification of Certain Mortgages

Chapter 13 bankruptcy allows the bankruptcy court to modify some debts secured by property if the amount you owe is greater than the value of the property. The amount of the debt equal to the value (or equity) of the property remains secured (meaning the collateral can be taken to pay the debt if you don’t make the payments). The remainder of the debt becomes part of your unsecured debt and is treated as a non-priority debt (which means you will pay less, or even none of it, in your repayment plan). This is called a “cram down.” For example, let’s say your loan is for $300,000 and the property value is only $200,000. If the loan is eligible for a cram down, $200,000 remains secured by the property and the remaining $100,000 is added to your unsecured debt.

For the most part, you cannot cram down a mortgage on your residence. However, cram downs are allowed if:

  • The mortgage is for a multiunit building
  • The loan is for other buildings or property not part of your residence (like a farm)
  • The loan is for a mobile home that is considered to be personal property, or
  • The loan is not secured solely by your residence (for example, both your residence and a business asset secure the loan).

If one of these exceptions applies, the court may cram down the loan, but you will have to pay off the entire crammed-down loan through your Chapter 13 repayment plan. For this reason, even if you meet one of the above exceptions, mortgage cram downs rarely make sense unless you will have the capacity to make a balloon payment at the end of your plan.

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Types of Foreclosure

There are two common types of foreclosure used in the United States: Judicial Foreclosure and Non-Judicial Foreclosure.

Judicial Foreclosure

Judicial foreclosure is allowed in all states, and occurs when the lender files a civil lawsuit against the borrower, with the entire process being handled by the court. Judicial foreclosures can be further divided into two types: foreclosure by sale, and strict foreclosure. Foreclosure by sale requires the home to be auctioned to the highest bidder with the lender placing the first, or opening, bid. These auctions are commonly referred to as sheriff sales. In a strict foreclosure, the court sets a date by which the owner must pay the mortgage, and if the owner fails to pay, the court awards ownership of the home to the lender with no auction taking place.
The judicial foreclosure process begins when the lender files their lawsuit, at which time they also file a lis pendens (LIS) on the property. The lis pendens is a document recorded with the County Recorder’s office, to let potential buyers, lenders, and others know of the pending foreclosure lawsuit. A second notice, the Notice of Foreclosure Sale (NFS), is typically filed once the court has set the auction time and bid amount.

Non-judicial Foreclosure

The non-judicial foreclosure process allows a lender to advertise and sell the property at a public auction, without court involvement, by following a process specified by the state. As the process is laid out in state laws, or statutes, the non-judicial foreclosure process is sometimes also referred to as Statutory Foreclosure. A key requirement for non-judicial foreclosure is that the borrower agreed to the process when they took the loan. To accomplish this, a power of sale clause is added to the mortgage, or deed of trust, which gives a third-party trustee the right to sell the property in the event the borrower does not make their payments. Given this clause, non-judicial foreclosures are sometimes referred to as foreclosure by power of sale.

In most non-judicial foreclosure states, the foreclosure process is started when the lender files a Notice of Default with the County Recorder’s office, putting the homeowner and anyone else who is interested on notice that the loan may be foreclosed on. A second notice, the Notice of Trustee Sale is typically filed 30 to 120 days later, depending on the state; and sets the auction date and time. In a few states, only the Notice of Trustee Sale is recorded.

Important Notes

There are two important things to keep in mind about both foreclosure processes:
Foreclosures happen to loans, not properties. As such, it is quite possible to have more than one active foreclosure on a single property at the same time. More importantly, buying a foreclosure at a state mandated auction doesn’t necessarily mean that you have purchased the property free and clear of other liens. For example, the buyer of a foreclosure is almost always responsible for any past due property taxes.

Foreclosure laws vary a great deal by State. One should never assume that anything they learn about the foreclosure laws of one state will apply to another.

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Non-Judicial Foreclosure Process

Prerequisite: Deed of Trust With Power of Sale

Contrary to popular belief, banks can’t just take back a property when an owner stops making payments. In non-judicial foreclosure states, the right to foreclose and sell the property actually lies with a 3rd party, known as the trustee; who has a fiduciary responsibility to both the lender and the borrower.

When you purchase a property, ownership is transferred to you using a document known as a deed. When you take a loan (in a non-judicial foreclosure state), you sign a deed of trust, which gives this third party trustee the right to sell the home if you fail to make payments. This power of sale is what makes non-judicial foreclosure possible.

The Notice of Default

The foreclosure process is first triggered when the lender notifies the trustee that the owner is not paying their loan, as agreed. Upon receiving that notice from the lender, the trustee will issue a Notice of Default, which is typically published in the local paper, posted on the property, and recorded at the County Recorder’s office. This notice provides the borrower with a period of time (varied by State), in which to either dispute the lender’s claim that the borrower has defaulted on their loan, or to pay it current prior to the house being sold. Here are some of the common features of a Notice of Default:
Puts owner and public on notice that the foreclosure process has started.
State statutes define when a Notice of Default can be issued.
Typically lists the default date and default amount. The default amount can be more than the loan amount in the case of a balloon payment.
Provides lender contact information to the borrower.

The Notice of Trustee Sale

Once the owner has received the notice of default and has been given an opportunity to bring the loan current, the trustee will proceed with scheduling the auction date and time if the owner has not yet brought the loan current. The Notice of Trustee Sale sets forth that auction date, time, location, and in some States, the opening bid amount. A few states only issue a Notice of Trustee Sale, but in those states there is usually an extended period of time before the Notices of Trustee Sale is issued; and the auction notice also serves as a Notice of Default as well. Here are some of the common features of a Notice of Trustee Sale:
Sets date, time and location of foreclosure auction.
State statutes specify the required information, format, and procedures for Notices of Trustee Sale, as well as how the trustee sale must be conducted.
Provides bid amount.
The published bid amount usually equals the principal balance + past due payments + late fees + foreclosure fees.
The Trustee Sale Auction
On the date and time of the trustee sale auction, one of four things may occur with the property:
The auction for the particular loan may be cancelled.

This may occur because the property was sold before the auction, and therefore the loan was repaid (or partially repaid in the case of a short sale); the owner was able to refinance the loan; the owner came up with the cash to bring the loan current; or, there may have been an error made in the sale process, and the trustee has decided it would be better to restart the process.
The auction may be postponed to a later date and time.

Common reasons for postponement include: mutual agreement, where the borrower and lender agree to delay the sale; beneficiaries request, where the lender decides to postpone; trustees discretion, where the trustee decides to postpone, often because it can’t reach the lender for bidding instructions; bankruptcy, which actually doesn’t completely stop foreclosure, but instead puts a temporary stay on the sale until the lender can get a motion granted by the judge allowing them to continue the sale; and operation of law, where a court has ordered that the sale not be held.
The property may be Sold to 3rd.

The loan being foreclosed on was offered for sale by the trustee, and a bidder (other than the lender) ended up purchasing the loan.
The property was Sold to the Bank.

Remember that it is the trustee, not the bank, that sells the home. Since the lender clearly has the most to lose in the transaction, and because they are the beneficiary of any funds received from the sale, they are allow to place the first bid, and are allowed to credit bid (bid without bringing cash to the sale), up to the amount they are owed.
Before bidding at auction it is important to consider the following factors:
Auctions open to the public—Typically held on the courthouse steps.

Payment requirements will vary from state to state, but generally the property must be paid for, in full, at the time of the auction, and bidders are usually required to show proof of payment, typically cashier’s checks or cash, in order to qualify for bidding.
Generally, you are not able to perform any inspections on the property, other than a visual inspection from the street or neighbors yard. Hidden work can be extensive, so auction investors need to be prepared to suffer losses from time to time.

Subject to existing liens and encumbrances. Remember that properties aren’t sold at foreclosure auction—loans are. One of the great things about foreclosure auctions is that it wipes out loans that came after the one being taken to auction. This can help clear up excess debt on the property, allowing it be resold at an affordable price point. The flip side is that the buyer is responsible for any loans or liens on the property prior to the loan being taken to auction. For example, delinquent property taxes, which are a lien on the property, are almost always the responsibility of the new owner.

No title insurance. One of the things that can help buyers sort out what debt they might get stuck with after buying a property at a trustee sale, is a preliminary title report; which would show which existing loans and liens the buyer would be responsible for. One important thing to note is that even the best title companies make mistakes, and occasionally miss items that can have a dramatic impact on the amount owed on the property. To reduce or eliminate this risk, title companies offer homeowners and lenders a title insurance policy which agrees to defend against or pay any claims that their preliminary title report failed to show. Unfortunately, such insurance is generally not available for purchase at trustee sale.

The Trustee’s Deed

Once the property is sold at auction, the property has been foreclosed. Ownership of the property is transferred to the new owner (whether the bank or a 3rd party bidder) with a Trustee’s Deed, and any secured interest in the property held by junior lienholders is wiped out.

Even though the bank or 3rd party bidder now owns the home, they may have to evict the current occupants. Eviction processes vary from state to state, and can also vary depending on whether the property is occupied by the former owners, or a renter. Lease agreements recorded after the foreclosing lien, are wiped out by the foreclosure, just like other liens and encumbrances.

California Foreclosure Process

CA Foreclosure Postponement Reasons

In California, foreclosure sales can be postponed for up to one year per CA Civil Code 2924 g (c) (2). The postponement reasons are outlined in 2924 g (c) (1), but the following names are commonly used at the foreclosure auctions.

Mutual Agreement

The most common postponement reason it simply indicates that the homeowner and the lender have agreed to postpone the sale. This may be the result ofa simple call by the homeowner requesting a little more time, or a more formal agreement like forbearance. Many homeowners do not realize when they enter a forbearance agreement that the foreclosure process continues; and if they miss an agreed upon payment, the property can be sold on the next scheduled sale date with no further notice.

Bankruptcy

When a homeowner files for bankruptcy protection, it puts an automatic stay on all debt collection actions, including foreclosure. Note that bankruptcy does not stop foreclosure, as many believe. Instead, it simply delays the sale of the property until the homeowner resolves the debt, or in many cases, the lender gets approval from the bankruptcy court to continue the sale – an order granting motion for relief from stay. The bottom line is that a home is a secured debt, and the lender has the right to take the security (the home) if the homeowner lacks the ability to pay the debt as agreed. Bankruptcy is only an effective tool against foreclosure if the homeowner will have sufficient income to pay their home loan and make up past due amounts once the bankruptcy plan is completed.

Beneficiary’s Request

A simple decision by the lender (beneficiary) to postpone the sale. Could be for any reason, including that they simply aren’t prepared to take the property to sale, or because they have reason to believe they are about to be paid (a closed escrow for which they have not yet received payment, for example).

Trustee’s Discretion

A simple decision by the trustee to postpone the sale. The most typical reason is that they are unable to reach the lender for sale instructions.

Operation of Law

Fairly rare, but used when a court orders the postponement of the sale. The most likely reasons for a court to make such an order would be in cases where there is a plausible allegation of fraud against the lender, or there are questions of material fact around the right of the lender to foreclose.
No matter what the postponement reason, a new notice of trustee sale must be posted and filed if the sale is postponed for more than 365 days.

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Stopping foreclosure

Homeowners who have failed, for one reason or another, to maintain the payment obligations of their loans, and are found in default on their loans, have a number of options available to them to stop the foreclosure process.

Bring the loan current

The best possible resolution for homeowners in default, is to reinstate the loan by bringing payments current, and paying all past due amounts.

Sell the property

A traditional sale of the property, in which the asking price covers the costs of the entire loan in default, would stop the foreclosure and eliminate the obligation of the homeowner to make monthly payments, by providing a payment in the full amount of the loan. Another option, should a conventional sale fail, is a short sale; this is the sale of the house, under agreed upon terms with all lien holders, to sell the property and settle the debts for less than the amount owed. Short sales can be difficult for properties with significant negative equity.

Refinance the property

Refinancing a property with more reasonable monthly payments and interests rates could potentially permit the homeowner to remain in the home, by paying off the current default obligation with the newly refinanced obligation.

Work with the lender

Loan modification: Modifies the terms of the original loan to enable the homeowner to stay in the home. May adjust interest rate, principal balance, length of loan, or other terms.

Forbearance

An agreement not to collect past due amounts for some period of time. Can be useful when the borrower fell behind due to temporary illness, or job loss, and can afford payments going forward; but can not afford to repay the past due amounts.

Repayment Plan

Similar to a forbearance, except the past due amounts are repaid in small amounts over a period of time, rather than being delayed to a future date.

Deed-in-lieu

Sometimes referred to as jingle mail (the sound of keys being mailed back to the lender), a deed-in-lieu is a method of simply handing ownership of the property back to the lender. Many lenders will not accept this deed, as they will then have to pay to remove other liens on the property; whereas those liens may be wiped out if they choose to foreclose.

Sue the lender

While it is often a good idea to have an attorney review loan documents for problems, and to help negotiate better loan modification terms; lawsuits are expensive and likely beyond the reach of most homeowners, unless working together in a class action suit.

Bankruptcy

Bankruptcy really only delays foreclosure. While Congress is considering allowing judges to modify loan terms, they currently cannot. As such, if the owner fundamentally can’t afford to make payments, the judge will likely have to grant the lender a motion allowing them to continue the foreclosure.

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The Effects on Homeowners & Renters

Credit Impact

A borrower that becomes delinquent on their mortgage, completes a short sale, gives the property back using a deed-in-lieu, or is foreclosed upon, will have their credit negatively impacted.
Negative impact on a credit report is generally limited to 7 years.
Current guidelines allow qualification for Federal National Mortgage Association (Fannie Mae) insured loan 5 years after a foreclosure, 4 years after a deed-in-lieu, or 2 years after completion of a short sale.
Declaring bankruptcy to delay a foreclosure, or to wipe away a deficiency judgement after foreclosure, will impact the borrowers credit report for 10 years.

Deficiency Judgments

Depending on the state and loan type, the borrower may owe the difference between the amount owed and the amount recovered at foreclosure auction (the deficiency). The owner may be able to negotiate a release in full, if they are able to complete a short sale.
It is important to note that if there are multiple loans on the property, for example a 1st and a 2nd mortgage, and only one forecloses, the borrower will likely remain liable for the loan that did not foreclose, even though the borrower no longer has any ownership of the home. Many make the mistake of thinking the loan that did not foreclose must get a deficiency judgment in order to collect, but because they did not foreclose, their loan remains in full force and effect against the borrower—even if the lenders secured interest in the property was wiped out by the foreclosure.

One-Action Rule

In states that offer it, a one-action rule prohibits lenders from pursuing a deficiency judgement if the lender chooses to foreclose using the non-judicial foreclosure process.

Purchase Money Rule

In states that offer it, the purchase money rule limits lenders that made purchase money loans to recovering their investment from the property alone, rather than the borrower. A purchase money loan is any loan made at the time of sale, and used towards the purchase of the property. The theory behind this rule is that the borrower could not have purchased the property without the lender, and therefore bears some responsibility as a party to the transaction.

Eviction

The prior owner or occupants will have to move after the sale, one way or another. Occupants refusing to move will only be faced with an unlawful detainer lawsuit, an eviction judgment, and forced removal by law enforcement. The new owner will likely also receive a judgment against the occupant, for market rents from the date of the auction sale to the eviction. Whether the prior owner, or a renter, it is usually best for the occupant to negotiate cash for keys with the new owner.

Cash for Keys

A buyer or lender at the foreclosure sale may offer cash to the prior owner or renter, to move quickly and leave the property clean. Cash for keys arrangements give occupants the resources to find new housing and is a great way to avoid the time and processing of an eviction.

Income Tax

A prior owner may receive a 1099 for the forgiven debt in the amount of the deficiency between the amount owed and the amount recovered at auction. Though recent law changes have eased the burden, this forgiven debt may be treated as income, resulting in state and federal income tax.
The owner may also be responsible for capital gains tax, though thanks to the substantial captial gains tax on a primary residence, this is unlikely to affect the majority of borrowers in foreclosure.
Tax implications are a critical consideration for homeowners in foreclosure, or those considering a short sale. Realtors® should urge clients to consult a qualified tax professional for advice on their particular situation.

Bankruptcy

Many homeowners will find themselves facing bankruptcy after foreclosure. Perhaps because the lender received a deficiency judgment against the borrower, or because a 2nd loan remains outstanding against the borrower after the foreclosure of a senior loan (even though that lender lost its secured interest in the property). Borrowers should fully understand these risks prior to allowing a loan to foreclose on their property.

Lease or Rental Agreements

Lease and rental agreements are generally treated as a lien against the property, and may be wiped out by the foreclosure of a senior lien. This typically leaves a renter in the position of becoming a holdover occupant after the foreclosure sale. While holdover occupants can typically not be locked out or forcibly removed, they typically retain no rights to continue on in the property and are subject to eviction. A number of laws have been enacted at the city, state, and federal levels that help renters by attempting to delay the eviction, typically through the requirement of an extended notice period prior to the new owner filing their unlawful detainer (eviction) lawsuit.

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How Bankruptcy Can Help With Foreclosure

Avoid or delay foreclosure of your home by seeking bankruptcy protection.

If you are facing foreclosure, bankruptcy might be able to help. In many cases, filing Chapter 7 bankruptcy can delay the foreclosure by a number of months. Some people may be able to save their home by filing for Chapter 13 bankruptcy.

What Is Foreclosure?

Typically foreclosure begins after a homeowner falls behind on mortgage payments. The lender begins the legal process of selling the home at auction in order to get payment for the loan. The process involves numerous steps, including notification to the homeowner.

This won’t happen overnight. Usually a lender won’t begin the foreclosure process until you’ve missed several payments, often three or four. That gives you time to try some alternate measures, such as loan forbearance, a short sale, or a deed in lieu of foreclosure. (To learn more about these options, see How to Avoid Foreclosure.)

But if you’ve already tried and failed with these measures, now is a good time to consider bankruptcy as a possibility for avoiding or stalling foreclosure. Here are some ways that filing for bankruptcy can help you.

The Automatic Stay: Delaying Foreclosure

When you file either a Chapter 13 or Chapter 7 bankruptcy, the court automatically issues an order (called the order for relief) that includes a wonderful thing known as the “automatic stay.” The automatic stay directs your creditors to cease their collection activities immediately, no excuses. If your home is scheduled for a foreclosure sale, the sale will be legally postponed while the bankruptcy is pending–typically for three to four months. However, there are two exceptions to this general rule:

Motion to lift the stay

If the Lender obtains the bankruptcy court’s permission to proceed with the sale (by filing a “motion to lift the stay”), then you may not get the full three to four months. But even then, the bankruptcy will typically postpone the sale by at least two months, or even more if the lender is slow in pursuing the motion to lift the automatic stay.

Foreclosure notice already filed

Unfortunately, bankruptcy’s automatic stay won’t stop the clock on the advance notice that most states require before a foreclosure sale can be held (or a motion to lift the stay can be filed). For example, before selling a home in California, a Lender has to give the owner at least three months’ notice. If you receive a three-month notice of default, and then file for bankruptcy after two months have passed, the three-month period would elapse after you’d been in bankruptcy for only one month. At that time the lender could file a motion to lift the stay and ask the court for permission to schedule the foreclosure sale.

How Chapter 13 Bankruptcy Can Help

Many people will do whatever they can to stay in their home for the indefinite future. If that describes you, and you’re behind on your mortgage payments with no feasible way to get current, the only way to keep your home is to file a Chapter 13 bankruptcy.

How Chapter 13 works

Chapter 13 bankruptcy lets you pay off the “arrearage” (late unpaid payments) over the length of a repayment plan you propose–five years in some cases. But you’ll need enough income to at least meet your current mortgage payment at the same time you’re paying off the arrearage. Assuming you make all the required payments up to the end of the repayment plan, you’ll avoid foreclosure and keep your home.

2nd and 3rd mortgage payments

Chapter 13 may also help you eliminate the payments on your second or third mortgage. That’s because, if your first mortgage is secured by the entire value of your home (which is possible if the home has dropped in value), you may no longer have any equity with which to secure the later mortgages. That allows the Chapter 13 court to “strip off” the second and third mortgages and re-categorize them as unsecured debt, which, under Chapter 13, takes last priority and often does not have to be paid back at all. It may be that you’ll have to give up your home no matter what. In that case, filing for Chapter 7 bankruptcy will at least stall the sale and give you two or three more months to work things out with your lender. It will also help you save up some money during the process and cancel debt secured by your home.

Saving money

During a Chapter 7 bankruptcy, you can live in your home for free during at least some of the months while your bankruptcy is pending–and perhaps several more after your case is closed. You can then use that money to help secure new shelter.

Canceling debt

Chapter 7 bankruptcy will also cancel all the debt that is secured by your home, including the mortgage, as well as any second mortgages and home equity loans.

Canceling tax liability for certain property loans

Thanks to a new law, you no longer face tax liability for losses your mortgage or home-improvement lender incurs as a result of your default, whether you file for bankruptcy or not. This new law applies to the 2007 through 2012 calendar years. (See Canceled Mortgage Debt: What Happens at Tax Time?)

However, the new tax law doesn’t shield you from tax liability for losses the lender incurs after the foreclosure sale if:

  • The loan is not a mortgage or was not used for home improvements (such as a home equity loan used to pay for a car or vacation), or
  • The mortgage or home equity loan is secured by property other than your principal residence (for example, a vacation home or rental property).

This is where Chapter 7 bankruptcy helps. It will exempt you from tax liability on losses the lender incurs if you default on these other loans.

Chapter 7 Cannot Cancel the Foreclosure

With all this debt being cancelled, you may be wondering why the foreclosure on your home won’t be cancelled too. The trouble is, when you bought your home you probably signed two documents (at least)–a promissory note to repay the mortgage loan and a security agreement that could be recorded as a lien to enforce performance on the promissory note.

Chapter 7 bankruptcy gets rid of your personal liability under the promissory note, but it doesn’t remove the lien. That’s the way Chapter 7 works. It gets rid of debt but not liens–you’ll still probably have to give up the house under the lien since that’s what provided collateral for the loan.

Chapter 7 Bankruptcy May Not Be Right For You

Not everyone can or should use Chapter 7 bankruptcy. Here’s why:

You could lose property you want to keep

Chapter 7 might cause you to lose property you don’t want to give up. As an example, if your wedding ring is particularly valuable, it may exceed the dollar amount of jewelry you’re allowed to keep in a bankruptcy (under something called the “jewelry exemption”). In that case, the bankruptcy trustee could order you to turn the ring over to be sold for the benefit of your creditors. For more on what property you can and can’t keep in Chapter 7 bankruptcy, see When Chapter 7 Bankruptcy Isn’t the Right Choice.

You may not be eligible

Even if Chapter 7 bankruptcy would work for you, you may not be eligible. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, you are not eligible if your average gross income for the six-month period preceding the bankruptcy filing exceeds the state median income for the same size household. Nor are you eligible if your current income provides enough excess over your living expenses to fund a reasonable Chapter 13 repayment plan. For more information about how the new income eligibility test (the “means test”) works.

Bankruptcy’s Effect on Your Credit Score

Both bankruptcy and foreclosure will damage your credit score. However, sometimes bankruptcy is the preferable option when trying to rebuild credit. Here’s why:

A foreclosure will damage your credit score for many years, will not get rid of your other debt, and is particularly harmful if you are house shopping.

In contrast, discharging your debts in bankruptcy will harm your credit score, but can help you rebuild your score quicker than after foreclosure. This is because bankruptcy will leave you solvent and debt-free, and therefore able to start rebuilding good credit sooner.

Keep in mind that the current mortgage meltdown and credit crunch (which are prevalent at the time this article is being written) may change the way bankruptcy and foreclosure affect credit ratings.

If All Else Fails: Relief From Debt and Tax Liability

If you’re certain you won’t be able to propose a Chapter 13 repayment plan that a bankruptcy judge will approve, and Chapter 7 will provide only a temporary delay from the foreclosure sale, then what’s the point of either?

If you have to lose your home, a bitter result to be sure, but sometimes unavoidable, you can at least view bankruptcy as the best way to get out from under your mortgage debt and tax liability. Bankruptcy also offers a way to save some money, which will help you find new shelter and weather the psychological and economic shocks that lie ahead.

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How to Avoid Foreclosure

Steps to avoid foreclosure, or at least minimize its impact

Millions of Americans have lost their homes, and foreclosures in the U.S. hit record numbers in 2009. If you’re having trouble paying your mortgage, learn about the steps you can take to avoid foreclosure or to minimize your debt after it happens. Quick action is the key to success — it can save your home and/or help protect your credit rating.

Don’t Walk Away: Consider Your Options

Don’t give up and let the lender foreclose on your home without considering your options. A foreclosure will hurt your credit rating and make it difficult, if not impossible, to buy another home anytime soon. In addition, if the profits from selling your home don’t cover the unpaid portion of your loan, your lender might sue you for the rest.

Your best options if you’re having trouble making mortgage payments include:

  • Negotiating with your lender
  • Getting government help
  • Filing for bankruptcy
  • Selling your home yourself, or
  • Giving your home deed to the lender.

These options are described in more detail below.

Beware of scam artists

People facing foreclosure are often preyed upon by others claiming they’ll help. Some homeowners have unwittingly signed documents giving these scammers title to their property, thus turning themselves into renters. Don’t sign anything without getting a professional opinion first.

Negotiating With Your Lender

As soon as you realize you’ll have trouble paying your mortgage — ideally, before you’ve missed any payments — contact your lender. Lenders have an incentive to negotiate with home loan borrowers, if only to reduce the number of foreclosures they’re dealing with. You might have to make a lot of calls to reach the right department or person, however.

Do it sooner rather than later

If you call soon, you may be able to work out a solution with your lender. But, if you’ve already missed three or four payments, it may be too late, and the lender may insist on foreclosure — or have already sent your file to an outside servicing company, which may not welcome requests to deviate from its standard procedures.

Possible solutions

The lender may accept partial payments for a few months (though you may have to agree to make up the difference later), accept a late payment, or agree to redo the terms of your loan.

What to say when you contact your lender

Here’s what you should ask for, in lender-language. (And, by the way, you’ll probably need to get to the right department first — it may have a name like “loss mitigation.”)

  • Forbearance. You make a reduced payment, or no payment, for an agreed-upon period of time. Usually, the lender requires you to make up the difference at a later time. The lender is most likely to agree to this if you can demonstrate that you will soon receive a bonus, tax refund, or some other extra cash.
  • Loan reinstatement. You agree to make up your missed (or reduced) payments by a specific date.
  • Loan modification. Your lender agrees to alter the terms of the loan so that you can better afford the payments. For example, the lender may agree to add your missed payments to your loan balance, to stretch out your loan over a longer term (which will lower your payments but result in more interest over the life of the loan) or to convert an adjustable rate to a fixed rate mortgage.

Getting Government Help

The U.S. government is working on various ways to help homeowners facing foreclosure. The two currently operating programs are:

The HOPE for Homeowners Act

This was enacted in 2008 to help homeowners refinance their currently unaffordable variable rate mortgages into affordable 30-year fixed rate mortgages insured by the Federal Housing Administration (FHA), if their lenders agree to participate. (However, critics allege that this program has helped far fewer people than intended.) For more information, see the HopeNow website at https://www.hopenow.com.

The Homeowner Affordability and Stability Plan

More recently, the Obama administration introduced a plan to help some homeowners refinance or obtain lower mortgage payments. For more information, see our blog post The Homeowner Affordability and Stability Plan as well as the government website, www.makinghomeaffordable.gov.

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