Mortgage Loan Modification and Bankruptcy

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If you've had a reversal of fortune, such as a layoff, and are finding it difficult to meet your monthly mortgage payment and other financial obligations, you have a few options available to you. You may choose to refinance or modify your home loan, or even file for bankruptcy. In some cases, you can combine these efforts, thereby keeping your home, lowering your home loan payments, avoiding default, and climbing out from suffocating debt.

What Is Loan Modification?

When a loan becomes difficult or impossible for the borrower to repay, he may be able to get a loan modification. A lender may modify the terms to lower the interest rate, extend the repayment term, or even change the type of loan to make it easier for the borrower to pay down.

Modifying a Mortgage Loan

The goal of a modification is to make the loan affordable for the borrower and prevent the lender from losing any more money than it has to. A mortgage 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 mortgage
  • Extending the length, such as from 30 to 40 years
  • Adding arrears to the back end of the loan
  • Deferring some of the principal
  • Forgiving some of the principal

With a modification, the lender doesn't have to deal with foreclosing on the home, which can be a costly process.

For some borrowers, a government program might help you secure more favorable terms; the Flex Modification Program is a foreclosure-prevention program for Fannie Mae or Freddie Mac loans. Traditional lenders may also have their own modification programs.

Some programs designed to help borrowers, such as the Home Affordable Modification Program (HAMP), the Home Affordable Refinance Program (HARP), and Freddie Mac’s HARP replacement program (FMERR), have expired.

Difference Between Refinance and Modification

A refinance replaces the old loan with a completely new one. Usually, refinancing is designed to reduce the interest rate or change less-favorable terms, such as an adjustable rate, to more favorable terms. You can refinance through your current lender or a new lender.

To refinance, you must be creditworthy, and the value of the property must not have dropped to the point the loan is underwater—meaning you cannot owe more than the property is worth.

A modification, on the other hand, 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. There is often more flexibility in what a lender may be willing to do to make the loan affordable, but the interest rate may be higher than the borrower could get in a refinance.

Modification During Bankruptcy

You don't need to wait until you're on the verge of bankruptcy to seek out a loan modification. However, if you've already filed for bankruptcy, you get to take advantage of the automatic stay, which is an injunction designed to stop foreclosures and other actions that collect on debts. It gives debtors (the people filing for bankruptcy) some breathing room while they eliminate their debt through a Chapter 7 case or set up a repayment plan in a Chapter 13 case.

How It Works 

When someone files a bankruptcy case, the bankruptcy court takes jurisdiction over almost everything that touches on the filer’s finances. The debtor is allowed to continue everyday transactions such as buying groceries and paying utility bills, actions deemed the "ordinary course of business." However, a loan modification is not an "ordinary course of business." 

Whether the bankruptcy court has to take action to approve the modification depends in large part on whether the case is Chapter 7 or Chapter 13. In a Chapter 7 case, which usually lasts four to six months, some lenders ask the debtor to obtain court approval. In a Chapter 13 case, 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.  

Chapter 13 Considerations

In a Chapter 13 case, the debtor proposes a plan to pay his debts by making a payment to a trustee, who then distributes the money received to creditors who have filed proper claims. The plan must include certain types of debt, such as past-due income taxes or domestic support obligations such as child support and alimony. It may include arrearages owed to the mortgage company as well as secured debt such as cars.

Because mortgage arrears are almost always rolled into the modification, the debtor’s attorney will also need to file a motion to modify the Chapter 13 payment plan if they want to remove the arrears. Depending on what else the debtor might have been intending to accomplish with the Chapter 13 plan—pay off priority debt such as recent income taxes or child support, or make a car payment more affordable—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 better to convert the case to a Chapter 7 or dismiss it altogether.

Entering the Modification Agreement

To get a home loan modification, you'll need to work with the lender by following a few steps.

Application: First is the application. Most lenders require proof of income to ensure that the borrower at least has a minimum income to make modified payments. Most lenders also require a credit report, although no minimum or maximum credit score is necessary. This is usually to determine how much other debt the borrower has to service each month.

Trial payments: 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 typical.

Final decision: 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.

Who Can Qualify?

Qualifying will depend on your loan servicer and whether your loan is owned by a bank or mortgage company or by an entity such as 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 your monthly income 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

An Example of Modification in Bankruptcy

Say that the debtor filed a Chapter 13 case and included $5,000 in past-due mortgage payments. After the 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 trustee, which includes the $5,000 owed to the mortgage company.

Assume 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 still owed on the arrears claim.

Removing Arrears

If the debtor doesn't want any more "extra" money to go to the mortgage company, 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, the bankruptcy judge will likely 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. 

Converting to Chapter 7

As an alternative, the debtor can forgo the plan modification process and file a motion to convert to a Chapter 7 bankruptcy or a motion to dismiss the case altogether, depending on what other financial considerations the debtor might have.