Bankruptcy and Mortgages

Politicians are pushing for amendments to bankruptcy legislation in an effort to help borrowers in distress keep their properties.

Unpleasant situations generally require unpleasant solutions. Having oppressive debt is no exception, but new bankruptcy legislation favoring borrowers might be coming down the pipeline.

You may have heard some politicians argue for bankruptcy reform as a means of easing the damage done by the subprime mortgage crisis. The topic has been in the news of late, as lawmakers question why mortgage debt gets special treatment in bankruptcy proceedings. As the talk wears on, many borrowers in distress are wondering what, exactly, that special treatment is and how it's likely to change.

Current law

Chapter 13 bankruptcy law divides debt into two types: secured and unsecured. Creditors that have security for the debt get to seize the collateral property and sell it to pay off the debt. Unsecured debts are lumped together into a debt consolidation repayment plan; the borrower must make payments on it for the following three to five years. The judge generally sets the interest rate on this debt based on prevailing market rates at the time-which is probably different from the rates that the past-due accounts originally carried.

The issues surrounding the treatment of mortgage debt become relevant when the value of the underlying property isn't sufficient to cover the debt. With other types of debt, the portion of the obligation that isn't covered by the collateral value is moved into the unsecured debt bucket and included within the repayment plan. Bankruptcy judges cannot, however, modify terms of mortgage debt, meaning that they can't change the interest rate or strip down the amount the borrower has to pay.

Because the mortgage debt can't be restructured, there's no other solution but for the lender to seize the collateral, sell it, apply the sales proceeds to the debt, and then write-off whatever balance is left. Sounds just like foreclosure, right? Up until recently, borrowers did get one perk for losing their home through bankruptcy rather than foreclosure; prior to 2006, debt forgiven outside of a bankruptcy proceeding was considered taxable income for the borrower.

Proposals for change

There are various proposals under consideration that would allow the bankruptcy court to make changes to the terms of mortgage debt. Should any one of these proposals pass, the bankruptcy court may be able to freeze an insolvent borrower's interest rate, lengthen the loan's repayment period, and reevaluate the home and/or reduce the principal balance outstanding. It remains to be seen whether these bills have enough support to be pushed through to law.

Considering all this, you might be wondering if there's a good or a bad time to file for bankruptcy. The answer is no. If you've exhausted all your options, including debt consolidation, and have no other way out of the unpleasantness, go ahead and file. Waiting around for legislation that may or may not help is likely to make things worse.