When struggling to pay the bills, individuals have the choice to either declare bankruptcy or go through a foreclosure. The choice depends upon several factors, including income, living expenses, other debts that need servicing (such as student loans and credit card debt), and outlook for future income growth. A foreclosure affects only the home while a bankruptcy affects all debts. There are different kinds of bankruptcy filings — a Chapter 7 bankruptcy covers all unsecured debt, meaning that individuals can emerge from it with no debts except a mortgage, car payments, student loans and unpaid child support. On the other hand, a chapter 13 bankruptcy does not eliminate debt but restructures it so that monthly payments are lowered for 3-5 years, allowing the individual to service the debt.
Foreclosure vs. Bankruptcy - Pros and Cons
Declaring bankruptcy may allow an individual to keep their house. As soon as bankruptcy is filed, an automatic stay order is filled, which suspends foreclosure proceedings until the bankruptcy has been resolved in court. A likely outcome of bankruptcy is keeping certain real estate, including the home, as long as the individual follows the terms of the agreement.
Bankruptcy does not always stop foreclosure; in some bankruptcies the debtor "surrenders the home" to the lender, and the lender then takes ownership of the property and sells is to recoup the debt. However, the important distinction here is that when a home is surrendered (and subsequently foreclosed) as part of bankruptcy proceedings, all mortgage debt is deemed settled. In contrast, in the case of an ordinary foreclosure, if the house sells at auction for less than the amount owed, the individual continues to remain liable for the difference (unless they live in one of three "non-recourse" states — AZ, TX or CA). This is because mortgages are "full recourse loans", allowing lenders to recover the entire amount owed to them.
Impact on credit history - Which is worse?
A bankruptcy stays on the individual's credit report for 10 years. A foreclosure will stay on the credit report for 7 years. While foreclosures stay on the credit report for a shorter duration, credit counselors believe that it has a worse impact on a person’s credit score than a bankruptcy that does not include the house.
How to decide
If you want to keep your home, Chapter 13 bankruptcy may be the best option, as it allows you to pay off at least part of the mortgage within 3-5 years. However, people must pass a means test to qualify for this. Chapter 7 bankruptcy cannot always prevent foreclosure, but it can limit the amount you pay back and has a less negative impact on a person’s credit score, and so is almost always preferable.
Not everyone can file for bankruptcy. Individuals are eligible for Chapter 7 bankruptcy if they earn less than the median income in their state and have not filed for bankruptcy in the past eight years. If a person’s income is more than the median income in the state, they can also file if, when the cost of food, rent and mortgage is subtracted, they earn less than $100 per month. In order to file for bankruptcy under Chapter 13, an individual must prove that they have enough income, after subtracting the cost of required expenses, to meet repayment obligations. For more details, see Eligibility Requirements for Chapter 7 and Chapter 13 Bankruptcy.
Foreclosure and bankruptcy are not the only options. Lenders are often willing to work with borrowers under programs such as HAMP to restructure the mortgage either by lowering the rate or, more commonly, by extending the term of the loan. This lowers monthly payments and helps borrowers get back on track. Another option is a short sale instead of a foreclosure.
In cases where the borrower has equity in the house i.e., the mortgage debt owed is lower than the value of the house, they can turn over the deed to the lender to avoid foreclosure.
Types of Bankruptcy
There are two types of bankruptcy: Chapter 7 and Chapter 13. Chapter 7 is straight bankruptcy, or liquidation, in which property is sold to pay creditors. In Chapter 13 bankruptcy, a payment plan is developed so that an individual can continue to pay off debts over three to five years. There are 4 bankruptcy filings in the Federal Bankruptcy Code (Title 11 of the United States Code):
- Chapter 7 - Liquidation
- Chapter 11 - Reorganization (or Rehabilitation bankruptcy)
- Chapter 12 - Adjustment of Debts of a Family Farmer with Regular Annual Income
- Chapter 13 - Adjustment of Debts of an Individual with Regular Income
The main difference between Chapter 7 and Chapter 11 bankruptcy is that under a Chapter 7 bankruptcy filing, the debtor's assets are sold off to pay the lenders (creditors) whereas in Chapter 11, the debtor negotiates with creditors to alter the terms of the loan without having to liquidate (sell off) assets.
Types of Foreclosure
Depending upon the state, foreclosures may or may not require judicial review. In a judicial foreclosure, the lender sues the defaulting borrower in state court in order to auction the property to recoup unpaid debts. In non-judicial foreclosures, the lender auctions the property without having to go to court. See Judicial vs. non-judicial foreclosures.
The bankruptcy process may be different depending upon the type of bankruptcy filing. But in general, the process begins when the borrower files a petition in bankruptcy court. Documentation such as a schedule of assets and liabilities, current income and expenses, copy of recent tax returns is required. There is also a filing fee of $250-350. Filing a bankruptcy petition automatically stays (stops) most collection actions against the debtor or the debtor's property. This includes foreclosure proceedings, which are stopped when the debtor files for bankruptcy. The court appoints a trustee who oversees bankruptcy proceedings, convenes a meeting with the creditors, and coordinates bankruptcy proceedings. Depending upon the type of bankruptcy, debts are either discharged or restructured. Creditors have to agree to the repayment plan or debt discharge plan and can present their objections or point of view to the court.
When the borrower falls behind on mortgage payments, the lender sends a "notice of default". In most states, the debtor must be in default for several months before the lender can initiate foreclosure proceedings.
The foreclosure process varies by state. In states that require judicial foreclosure, the lender must prove in court that the debtor has defaulted on their loan obligations. The lendor then takes possession of the property and sells it either at an auction or through a realtor.