Mortgage Loan Modification and Bankruptcy
There was a time just a few years ago when I could not have written anything of substance about mortgage modifications in a bankruptcy case. That’s because the banks were in a mess and the modification programs were a joke. Clients were constantly being told that paperwork was missing. They would fax and email documents over and over again. Every time they contacted the bank, they would be referred to a different customer service employee, none of whom could seem to locate accounts or files or documents.
Clients would give up after numerous tries.
Today, I’m happy to say the banks seem to have turned a corner. While there are still pockets of discord, on the whole, the banks and mortgage companies appear to be doing a fairly credible job of getting their customers through the process without too much stress.
Many of our clients come to us on the verge of bankruptcy. Sometimes they just aren’t aware of their opportunities to modify their loans. Sometimes they are too late before they try to modify. Sometimes, the banks continue with foreclosure even though their customers are trying to sell the property, get refinanced, or have started the modification process. We file a bankruptcy case to take advantage of the automatic stay, an injunction designed to stop these foreclosures and other collection actions, give debtors (that's what we call people who file bankruptcy cases) a little breathing space, and either eliminate much or all of the rest of their debt through a Chapter 7 case, or set them up on a repayment plan in a Chapter 13 case that will address not only their mortgage arrears but other obligations as well.
The federal modification program is called the Home Affordable Mortgage Program or HAMP. In this article, we will look at what HAMP can do, and how it works in a bankruptcy case.
So What’s the Difference Between a Refinance and a Loan Modification?
If you need new terms or a way to make your home more affordable, you have two choices: refinance or modify.
A refinance replaces the old loan with a completely new one. Usually, a refinance is designed to reduce the interest rate or change less favorable terms, like an adjustable rate, to more favorable terms. It can be accomplished by the current lender or a completely new lender. It requires that the borrower be creditworthy and that the value of the property has not dropped so that the loan is underwater (the borrower owes more than the property is worth.
A modification changes the terms of the current loan. It does not require the same level of creditworthiness that a refinance does, although the borrower does have to show that she will have enough income to make the payments. In fact, the loan modification program is designed to help homeowners who have suffered some kind of financial reversal. It may be permanent or it may be temporary if there is some reason to suspect that the borrower’s circumstances will change. There is often more flexibility in what a lender may be willing to do to make the loan affordable, but the interest rate will often be higher than the borrower could get in a refinance.
Can You Still Get a Mortgage Modification During a Bankruptcy Case?
Yes. In fact, many of my clients have successfully modified their loans and emerged from bankruptcy with fewer debts and an intact and up-to-date mortgage.
Who Can Qualify for a Mortgage Modification?
This depends on your servicer and whether your loan is owned by a bank, mortgage company, or an entity like Fannie Mae or Freddie Mac. Each has its own requirements and criteria. But in general, you will probably qualify if
- You are spending more than 31% of income monthly on housing costs (mortgage payment, insurance, property taxes, homeowners association dues).
- You are otherwise not eligible for a refinancing of the mortgage.
- You are either delinquent or in danger of default because of a change in financial circumstances.
- The value of the house has declined, and you owe more than the house is worth.
HAMP modifications can be used to modify loans on primary residences and certain rental properties.
What Does the Mortgage Modification Entail?
First is the application. Most lenders will require proof of income to ensure that the borrower at least has a minimum income to make modified payments. Most lenders will also require a credit report, although there is no minimum or maximum credit score necessary. This is usually to determine how much other debt the borrower has to service each month.
Second is the trial period. Once all the paperwork is complete, and the lender determines that the borrower will probably meet its minimum requirements, the borrower will be offered an opportunity to make a series of trial payments. Three payments are the number I see most often.
Once the trial payments have been successfully made, the lender will make a final decision on the modification and offer the modification to the borrower.
What Loan Terms Will Change?
The goal of a HAMP modification is to make the loan affordable for the borrower and prevent the lender from losing any more than it has to. The lender can change virtually any of the payment terms including
- Lowering the interest rate
- Converting the loan from an adjustable rate to a fixed rate
- Extending the length, for example from 30 to 40 years
- Adding arrears to the back end of the loan
- Defer some of the principal
- Forgive some of the principal
What About Modifications and Bankruptcies?
When someone files a bankruptcy case, the bankruptcy court takes jurisdiction over almost everything that touches on the filer’s finances. The debtor (that’s what we call the person who files a bankruptcy case) is allowed to continue everyday transactions like buying groceries and paying utility bills, things we call "ordinary course of business."
A loan modification is not "ordinary course of business." Whether the bankruptcy court has to take action to approve the modification depends large part on whether the case is Chapter 7 or Chapter 13. In a Chapter 7 case, which will usually last four to six months, some lenders will ask the debtor to obtain court approval. In a Chapter 13, the debtor is always required to obtain court approval regardless of whether the lender requires it or not. To get that court approval, the debtor’s attorney will need to file a motion with the court.
In a Chapter 13 case, the debtor proposes a plan to pay his debts by making a payment to a trustee who distributes the money received to creditors that have filed proper claims. The plan must include certain types of debt like past due income taxes or domestic support obligations like child support and alimony. It may include arrearages owed to the mortgage company and secured debt like cars and appliances.
Because in virtually every case, the mortgage arrears will be subsumed into the modification, the debtor’s attorney will also need to file a motion to modify the Chapter 13 payment plan to remove the arrears. Depending on whatever else the debtor might have been intending to accomplish with the Chapter 13 plan -- pay off priority debt like recent income taxes or child support, or make a car payment more affordable by including it in a Chapter 13 plan -- the debtor may decide that a Chapter 13 case is no longer necessary or helpful. At that point, she can consider if it might be advisable to convert the case to one under Chapter 7, or dismiss it altogether.
How it Works in a Bankruptcy Case
Here's an example: Let’s say that the debtor filed a Chapter 13 case and included $5,000 in past due mortgage payments. After the Chapter 13 case is filed, the debtor applies for a loan modification with his mortgage company. While in Chapter 13, he continues to make payments to the Chapter 13, which includes the $5,000 owed to the mortgage company.
Let’s say that a year after the case is filed, the mortgage modification is approved. By then, the lender has been paid $1,000 through payments to the Chapter 13 trustee. The loan modification includes the $4,000 that remains owing on the arrears claim.
The debtor doesn't want any more "extra" money to go to the mortgage company, so his attorney will have to do two things. First, the attorney will file a motion with the bankruptcy court asking the court to approve the mortgage loan modification. Sometimes the motion has to be set for a hearing before the judge. Sometimes it can be on file for a set amount of time - often 24 days - to allow any interested party to object to it. If no party objects, and the terms are favorable to the debtor, it is highly likely that the bankruptcy judge will approve it. If a party objects to it, the modification will be set for a hearing to allow all parties to testify and argue to the judge.
Once he has an order from the court approving the modification, and the debtor actually enters into the modification agreement, his attorney will ask the court to change the terms of the plan to remove the arrears to the mortgage company. This will also entail a motion. The process is similar to the motion for the loan modification. The motion is set for hearing, or it stays on file for some period of time to give creditors a chance to vet it and object, if appropriate.
Or the debtor can forgo the plan modification process and file a motion to convert to a Chapter 7 or a motion to dismiss the case altogether, depending on whatever else the debtor might have lurking in his financial picture. Learn about bankruptcy software.