Bankruptcy and Loan Modification

When homeowners fall behind on their mortgage payments and face foreclosure, bankruptcy and loan modification are two possible means to prevent the loss of their property. Although these are two different means for avoiding foreclosure and restoring a past due loan to current, they are often used together.

A loan modification is changing an existing loan agreement between a lender and a borrower; the parties (lender/bank and borrower/homeowner) stay the same, but the terms of their agreement are modified. Commonly modified terms include extending the time to repay the loan, changing the interest rate, waiving fees and penalties for late or non-payment, and adding any missed or overdue payments or “arrears,” to the end of the loan as a balloon payment, which can often be paid over time by refinancing at a later date. When the modification goes into effect, the mortgage is brought current again, and the homeowner continues making the new payments just as they did previously, before falling behind.

Borrowers who earn a steady income, can afford paying for a part of their debt, and wish to protect their home from foreclosure often opt for filing for Chapter 13 bankruptcy rather than filing under Chapter 7 bankruptcy. By combining a Chapter 13 bankruptcy with a loan modification, borrowers can:

  • Stop a foreclosure, as filing for bankruptcy provides an automatic stay that pauses any attempts to collect missed payments.
  • Resolve their debt problems.
  • Motivate the borrower to negotiate a loan modification that meets the borrower’s needs.

When filing for Chapter 13 bankruptcy, the homeowner proposes a repayment plan based on a meticulous calculation of their income, various debt, payments, and costs of living. This plan needs to be realistic, lawful, and made in good faith. If the court approves it, the borrower is able to reorganize the debt, making monthly payments over the course of three to five years. Contrary to Chapter 7 bankruptcy, the longer term for paying off debt means the borrower won’t need to liquidate any property or other assets to wipe out the debt fast.

Filing for a Chapter 13 bankruptcy is often combined with a loan modification application. Under Chapter 13 bankruptcy, the homeowner may pay only a fraction of unsecured loans (like credit cards and medical debt),, challenge costs and fees related to missed payments, or “cram down” certain secured loans, which forces lenders to accept less than the amount owed on a loan for certain types of property, like taking face value for a car instead of getting the total amount that is owed under the current loan. Additionally, if the house is “underwater” or “upside down,” both meaning that more is owed on the primary loan than the house is worth, Chapter 13 can allow the debtor to “lien strip,” which removes or reduces a second mortgage. By eliminating and reducing other debts, the mortgage loan becomes more affordable. This works as an incentive for the lender to accept a loan modification and makes it easier for the borrower to pay off the mortgage.

What Is a Loan Modification?

Applying for a loan modification means asking the lender to change the terms of the loan. Such changes may involve:

  • A lower interest rate, leading to lower monthly installments and lower accrual of interest.
  • An extension of the time to repay the mortgage, which stretches the payments over a longer time and lowers the monthly amount to be paid.
  • Forgiveness of fees and penalties for late payment or non-payment.
  • Making the “arrears,” or past due amount, payable at the end of the life of the loan, which allows the homeowner to pay down the loan and make that “balloon payment” at the end, or to refinance it a few years before the loan is up.
  • In rare cases, the modification may include a decrease of the loan balance or a reduction on previous principal or interest.

Loan modification involves the voluntary agreement of the lender and brings the loan current again.
Although Chapter 13 bankruptcy often works as a loan modification in practice, it is not unusual for a struggling homeowner to proceed with a further loan modification after filing for bankruptcy. Such modifications need to be approved by the bankruptcy judge and result in a new Chapter 13 repayment plan.
A homeowner may wonder if they really need a Chapter 13 bankruptcy once they have an efficient loan modification. Usually, if a homeowner has important debt other than the mortgage loan, bankruptcy should still be considered as an option. If, on the other hand, the major debt is the mortgage loan, it may be better not to file for bankruptcy. The answer depends on each particular case, which is why an experienced attorney is crucial in helping you make the right choice for you.

Hiring an attorney when applying for loan modification will also help the homeowner prepare a robust application file. The application file includes a variety of documentation such as bank statements, tax returns, appraisals, written statements on the reasons for the missed payments, and more. An attorney can evaluate a case and determine whether it is in the best interests of the homeowner to proceed with a Chapter 13 filing or not. An attorney will also guide the borrower through any changes that need approval from a judge.

Mortgage Modification

Several types of loan modifications for mortgages are available to homeowners. These include:

Repayment Plan

Sometimes, the borrower and the lender will agree on a repayment plan that brings the borrower current on all fees and payments. For example, an upfront lump sum may be paid and increased monthly payments may be made until the debt is settled.

Loan Extension

A loan extension gives the borrower more time to fulfill the terms of the loan. While borrowers pay more interest over the life of the loan, the monthly payments will be reduced, which may make them easier to pay.

Forbearance

Typically, a forbearance is a short-term mortgage modification to help the borrower get through financial hardships. The lender will temporarily suspend or reduce payments. However, the lender still expects to recoup the full difference once the forbearance period ends—unlike other types of modifications, which typically reduce payments and then add them to the end of the loan. Recently, many homeowners have been given a Covid-19 forbearance, allowing them to suspend payments, only to receive a nasty surprise when the lender expects those payments to be made in a lump sum at the end of the forbearance period and offers few other options.

Rate Reduction

This mortgage loan modification reduces the interest rate of the loan. This reduction may be either short-term or long-term.
If the rate reduction is short-term, the interest rate will be lower for a set period of time but will revert to the original rate once that is over.
Sometimes, the reduction is long-term, even lasting the life of the mortgage. This is usually the case if the lender doesn’t expect the borrower’s payment abilities to return to full capacity before the mortgage period is over.

Principal Deferral

A mortgage loan may be lowered and the amount of principal that is paid off with each payment reduced as well. This is called a principal deferral. The deferred principal amount is due when the loan matures or when the property is sold or refinanced.

Government Programs

During the housing foreclosure crisis between 2007 and 2010, the government established several government loan modification programs, including:

  • Mortgages insured by the Federal Housing Authority may be eligible for modification through the FHA-HAMP program.
  • Government-sponsored mortgage company Fannie Mae has a program called Flex Modification.
  • The U.S. Dept. of Veterans Affairs offers military veterans mortgage delinquency counseling.

The fallout from the impact of Covid-19 has led to several new housing assistance programs and may lead to the creation of other, similar programs in the near future.

Are There Are Risks to Modifying My Mortgage?

In many cases, filing for Chapter 13 bankruptcy may hasten financial recovery. Even without that, modifying a mortgage loan may be a good solution for homeowners who struggle with their mortgage repayment plan. However, it comes with risks attached. The more aware a borrower is of the possible negative consequences of modifying their mortgage loan, the more informed their decision will be.

An important risk related to filing for Chapter 13 bankruptcy is the limited ability to contract a new loan in the future. During the 3-5 years period of the bankruptcy repayment plan, the borrower is prohibited from taking on any new credit without the approval of the Bankruptcy Court. This can make life difficult in emergency situations. Even if they find a lender willing to work with a Chapter 13 debtor, they need court permission to take on the new loan.
Also, filing for a Chapter 13 bankruptcy is reflected on the filer’s credit report, and may have either a positive or negative impact on their credit score. Of course, this also applies to missed payments, which can stay on a credit report for as long as seven years, and are always a negative mark against your credit score.

After discharge, one can usually find credit if needed. However they may need to pay a higher interest rate for the first years after filing bankruptcy. That said, some people leave bankruptcy with higher credit scores than they had at the time of filing and it’s always an individual, case-by-case basis, as to whether a Chapter 13 will increase or decrease your credit score. What is important is that filing can help you get on top of managing your debts and give you a chance to make all your payments and build excellent credit in the future.
Other disadvantages related to loan modification are:

  • A longer period to pay off the mortgage loan. If the goal is to become debt-free as soon as possible, loan modification is not an efficient option.
  • Paying more interest over time. Due to the extension of the loan duration, the borrower may end up paying more interest over the new life of the loan than originally agreed upon. This is especially the case if the loan modification does not involve a reduction of the interest rate along with the reduction of the monthly installment.
  • Loan modification costs. There may be fees and costs involved in modifying a mortgage loan.

Finally, if a homeowner proceeds with loan modification without filing for a Chapter 13 bankruptcy, they have no protection against foreclosure during the negotiation period. If the foreclosure process has already started, loan modification alone cannot stop it. If the homeowner stops making the payments agreed in the loan modification, the lender can still start a foreclosure process on the house.

Can This Affect My Business?

Chapter 13 Bankruptcy

Business entities such as partnerships, corporations, or LLCs, cannot file for Chapter 13 bankruptcy. However, sole proprietors can, as the company itself is not a separate legal entity from its owner, unlike other types of company.

A person who is a partner in a partnership can still file for Chapter 13 bankruptcy as an individual. However, doing so may result in dissolving the partnership, as many partnership agreements include clauses that dissolve the business if one partner files for bankruptcy.

Loan Modification

It usually has no effect on the business if a borrower who participates in an LLC or any type of corporation files for a loan modification. This is not the case if the borrower is the sole proprietor of a company, as all of a sole proprietor’s debt and assets—both individual and business—are taken into consideration.
As for a business, a loan modification has the same pros and cons as for the sole proprietor: it may help the business clear debt, but at the same time it affects its credit score and its ability to obtain new loans, which may be critical to its success. If a business struggles with debt, the usual path to follow is commercial loan modification or a workout plan to prevent the loan from going into default.  

Do you wish to explore your loan modification or bankruptcy options? Our legal team here at Roemerman will help you make the most of the bankruptcy tools available to you.

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