The answer, surprisingly enough, is yes and no. In order to explain this further we need to talk about the different types of personal bankruptcy a homeowner can file, how they work and how it could affect your position as an investor.
The most common form of personal bankruptcy is known as Chapter 7. This is a bankruptcy motion where a homeowner tells the court they are no longer able to make any payments to their creditors and asks for all of their debts to be discharged or dismissed.
Following this motion, the court will then look at the homeowners’ non-exempt assets and determine what they can sell to raise money. A trustee is then appointed to overlook the sale of those items and collect and hold the funds. Those funds will then be distributed to all creditors in accordance with the judge’s ruling. Many creditors will receive nothing or at best a few pennies on the dollar. These creditors are now prevented from ever trying to collect again.
The other type of personal bankruptcy is the Chapter 13 filing. This differs from Chapter 7 because here a homeowner is telling the court they wish to repay all of their creditors but just do not have the money to do so at the time. In this case, the court will look at the homeowner’s income and assets, along with all of their debts, before determining how much money they should place in escrow with the court trustee each month to payoff those debts. The trustee will then distribute this money to the creditors accordingly. In this scenario, the debtor would make partial payments to all of their creditors and the creditors must stop all collection activity.
So how does all of this relate to a foreclosure?
Well the first thing a bankruptcy filing does is prompt the court to issue what is called an “Automatic Stay”. This means that the homeowner’s creditors must immediately cease all collection activity until the bankruptcy is resolved.
So when an automatic stay is issued, any lender who is about to file a foreclosure action against a home cannot do so and will be forced to delay any action for three to four months. Filing a bankruptcy action can even stop a foreclosure sale on the morning of the auction.
However, struggling homeowners shouldn’t automatically embrace bankruptcy as a solution to their problems. As with all laws, there are exceptions. A lender can ask for a “Motion to Lift the Stay”. A lender may be granted a motion to lift an automatic stay if they can prove they will suffer an irreparable harm by allowing the stay to remain in effect, or if they can show the homeowner has filed multiple bankruptcy petitions in the past with the sole purpose of obtaining an automatic stay to keep the home from being sold at auction.
If the homeowner filed a Chapter 7 bankruptcy petition then the automatic stay for the most part just buys them time. It gives them an additional three to four months to be able to make arrangements to move, possibly come up with the funds to bring the loan current, or come to a new agreement with the lender. However at some point the automatic stay will be lifted and the home will go into foreclosure.
A Chapter 13 bankruptcy petition is dealt with differently though – in this case, the court will order that whatever the current arrears on the property are should be added to the homeowner’s other debts. This money now becomes part of the Chapter 13 trustee distribution. What this means is that so long as they can go back to making their normal mortgage payment and pay the monthly amount to the trustee to divide up amongst all their creditors, they can keep the home.
This situation normally works best when someone has gone into default due to an illness or loss of work for a period of time. They have since recovered and can continue making their normal debt payments but have fallen so far behind they can’t catch up without the court’s help.
For investors following a home through the foreclosure process, should the home suddenly be pulled off the market, it’s worth continuing to track it. Find out if it was pulled because of a bankruptcy filing by the homeowner. If it was a Chapter 13 filing then more than likely the homeowner is planning on reaffirming the debt and keeping the house. However, if it is a Chapter 7 bankruptcy then follow it closely because more often than not that home will be back on the auction block once the automatic stay is lifted.