Nolo’s Bankruptcy & Foreclosure Blog

If foreclosure looms because you've missed some payments or you think you will soon, it's time to face what's probably the toughest question of the whole process: Does it make economic sense to keep throwing money into your house?

If your mortgage debt is significantly more than the value of your home -- which is becoming the norm rather than the exception -- the main question is whether the property's value will bounce back enough to give you at least a little equity in your house in the not too-distant future.

If you owe at least 25% more than the value of your house -- whatever you determine it to be -- the wise economic decision, under the present circumstances, would be to extract as much money as you can from the house now by stopping your mortgage payments and staying in the house payment-free for as long as possible, which can be as long as a year in many states.

How do I know what the market will do in the future? I don't. And I always keep in mind the advice that Mark Twain is reputed to have given a young man: "Buy land, they're not making it anymore." Also, no formula exists that can predict how soon a particular real estate bust will be over. But, while the general history of real estate booms and busts might indicate a fairly speedy recovery, history has never seen a combination of such factors as:

• the federal government takeover of the two major government housing loan entities
• the implosion of the finance industry
• a complete collapse of the residential loan market
• continued high numbers of foreclosures 
• the inability to accurately determine residential real estate values
• super-tight credit markets
• the likelihood of a deep recession, and
• tapped-out consumers who can't make good on any of their debts, mortgages included.

The fact is, there is no guarantee your house will ever recover its original value. As the old saw goes, you don't want to throw good money after bad. If the housing market fails to rebound because of these factors (and others sure to come), every economic sacrifice you make now to keep your house could be for naught if you ultimately lose it.

An article on Newsweek's website asserts that chapter 7 bankruptcy filings are following an upward trend, with more and more people seeking bankruptcy protection, despite recent changes to the law making it more difficult to file. Readers of this blog will know that I advocate bankruptcy as a way to avoid foreclosure; according to Newsweek, filing bankruptcy to deal with an imminent foreclosure is one of the reasons for the boom:

In some cases struggling homeowners are filing to prevent foreclosure. (A record high 243,353 homes went into foreclosure in April, according to data released on May 14 by RealtyTrac.) Squeezed by rising costs for everyday necessities like gas and groceries and unable to tap into their homes for temporary relief -- declining values have left some people owing more than their homes are worth; it's also more difficult to get home equity lines of credit or loans -- many people have turned to their credit cards "as a last resort," says Robert Lawless, a professor of law at the University of Illinois who follows bankruptcy trends.

While digging the debt hole deeper seems like it might be a good idea in the short term, filing bankruptcy now will help you avoid the costly penalties that credit card companies will saddle you with as your balance goes ever-upward. If you're thinking of filing for chapter 7 bankruptcy, be sure to visit LegalConsumer.com, my co-blogger's website, to try out his free means test calculator. The calculator can quickly tell you whether you qualify for chapter 7 bankruptcy under the changes in the law that went into effect in early 2008.

As the credit crisis continues and foreclosures continue to rise, Nolo has gathered the most relevant and helpful articles and tools for anyone facing foreclosure. There, you can find articles by me and my colleagues on everything from reducing the number and amount of mortgages on your home, to tips on how to spot the shady characters who will try and take advantage of you at a most vulnerable moment -- when you're struggling to hang on to your home. And, of course, there are answers to those nagging questions that need to be answered immediately -- like how long you can stay in your home once foreclosure notice has been given.

To find out what the law has to say about these issues and more, check out the brand new Foreclosure area on Nolo.com. Soon we'll be adding an article on foreclosure basics and an FAQ with answers to common foreclosure questions.

The subprime mortgage and credit crisis shows no sign of waning anytime soon, and if you're one of the millions being foreclosed on, panic may be quickly setting in. But just because a solution seems unreachable doesn't mean that you can't plan ahead to minimize the possibility of foreclosure or mitigate the damage if you find yourself sliding toward it.

Lately, I've been working with my colleagues at Nolo to produce useful materials that will help anyone in any stage of the foreclosure process -- from those struggling with their new jumbo loan repayments to those with an eviction notice already pasted to their front door. Here are a few of the articles I'd recommend to interested readers:

• My latest article covers the process of reducing your mortgage obligations to help you avoid foreclosure and stay in your home.


• Similarly, Ilona Bray gives you a rundown of all the ways you might be able to stay in your home and keep foreclosure at bay, as well as what to do if you discover that foreclosure is inevitable.


• A cautionary article: Don't Lose Your Home to Foreclosure "Rescue" Scammers. Many unscrupulous people are using the mortgage crisis to prey on those going through one of the most difficult times in their lives. This article gives you the tools to recognize those attempting to defraud you, and how to check up on the legitimate rescuers.


• What happens when your landlord's rental property is being foreclosed upon? Janet Portman provides the information any renter in this situation will need, including warnings about angry, law-breaking landlords and solutions for tenants who find out their new landlord is the bank.

If you're like many homeowners, your home is encumbered with a second or third mortgage (or deed of trust), and perhaps a home equity loan. Numerous articles describe you as using your home like an ATM machine. Having all these secured debts on your home is tantamount to a juggler having too many balls in the air -- at least one must fall, sooner rather than later.

If, for one reason or another, you just can't keep up, you may be able to avoid foreclosure if you pay the right loan and either blow off the rest, or at least make reduced payments. In almost every case, the right loan to stay current on will be your first mortgage or deed of trust. While I'm always hesitant to tell people to stop meeting their shelter obligations in full and on time, sometimes it's the only rational thing to do -- as wrong as it may feel to many of you. If reducing the amount you throw at your home every month will let you stay there and keep your ahead above water, at least until you can work out a better solution, I'm all for it.

How does this work? When you originally took out the loan to buy your home, you agreed to have the loan (or loans) secured by a mortgage or deed of trust (depending on the state where the property is located). (For the rest of this blog, I will use the term "mortgage" to refer to both mortgages and deeds of trust.) By recording the mortgage in your local land records office, the lender created a lien (legal claim) on the property, which can be enforced by foreclosure if the payment terms of the mortgage document aren't met. As you probably know, in foreclosure the property is sold to make good on the promissory note underlying the mortgage.

The main loan you used to buy your home is termed a "first mortgage." Why first? It's almost always recorded first and gets paid first in case of a sale. In the same manner, a second loan secured by the home is a second mortgage. For example, it's common to use a first mortgage to pay 80% of the sale price and get a second mortgage for the additional 20%. And that's not all. In the bubble years, home value appreciation supported additional loans against the home, often in the form of a home equity lines of credit. As with the first mortgage, the lender's primary remedy for a default on these additional loans is foreclosure.

For foreclosure to be an effective enforcement remedy there has to be enough equity in the home to pay off the holder of the loan being foreclosed. And if the home is sold in foreclosure, all senior lien holders (in that a first mortage is senior to a second mortgage) have to be paid off first. For that reason, until the last several years, banks wouldn't lend in the absence of good credit and a healthy chunk of equity to secure the loan. In the bubble years, however, many loans were made on the expectation that values would rise fast enough to provide adequate security for the prospective loan, even if there was no measurable equity at the time. Also, liberal (dare I say "dishonest" or "fraudulent"?) appraisals were easy to come by.

It's easy to see what happened when the crash came. Not only did homes stop appreciating in value, but the values continue to plummet, erasing whatever equity there may have been at the time of the loan as well as erasing the hope of equity to come. Importantly, then, if in your case one or more of the loans on your home has become unsecured-in-fact -- or never was secured to begin with -- skipping payments won't result in a foreclosure action. Sure you may get sued, but the lender's only remedy is to get a money judgment and put another lien on your home, just in case some equity develops in the future. And lawsuits usually take a long time to develop, giving you the opportunity to raise some money from another source and make up the payments or settle with the lender for less than you owe. Remember, the only reasoning for this strategy is the assumption that you can't afford to remain current on your "mortgage debt."

To determine whether the loans on your home are secured or unsecured (as a factual matter), begin with your home's value (be optimistic, but sensible) and subtract the first mortgage. If you hit zero or below, foreclosure is not a viable remedy for the other lenders, since there is no equity left in the home to pay them off. Assume, for example, that your home is worth $400,000. You have a first mortage of $350,000, a second mortgage of $50,000 and home equity line of credit worth $25,000. When you subtract the first and second mortgages from the home's value, you get zero. If you stop making payments on the home equity loan, the lender won't benefit from a foreclosure, since there wouldn't be anything left from the sale after the first and second mortgage holders are paid.

Of course, it's not always that simple. Sometimes a second or third mortgage is partly secured and partly unsecured. In that case, a foreclosure by the junior lien holder might recover some of the lien but not all of it. On the other hand, when foreclosure does occur, in most states it wipes out all the junior liens, regardless of the equity in the home. For instance, in the earlier example, if the owner of the first mortgage foreclosed on the loan, the liens held by the holders of the second mortgage and the home equity line of credit would both be extinguished, even though there was still equity (at least theoretically, since foreclosure sales usually accept bids far lower than the perceived market value).

Just about everyone in and out of government is talking about putting cash in the hands of consumers to stimulate the economy. The only real points of disagreement seem to be which consumers and how much. The President wants to rebate taxes to the people who make enough money to pay taxes--the middle- and upper-classes, by definition. Democrats want people who are too poor to pay taxes to also get a piece of the action. The idea, of course, is that the recipients of this largess will kick-start the economy by immediately spending the money on consumer goods and services--appliances, cars, clothing, vacations.

The last time the government sent checks to people to help out the economy was in 2001, and many recipients used the money to pay down their debt and keep the collection agency wolves from their doors. This time around, the national consumer debt has more than doubled--and it is even more likely that the loan sharks will gobble up most of the government's gifts hook, line, and sinker. Maybe increasing the government debt by $100 billion in order to fatten the credit card and consumer finance companies will put some more credit in consumers' hands--just what we don't need--but if we follow President Bush's lead, the folks who own the finance industries will be the ones who ultimately benefit.

Here is a modest proposal that will help folks who really need help as well as make our economy stronger: Everyone with significant credit card debt (which is just about everyone) should use his or her check to file for bankruptcy. The entire process can cost as little as $600 for people who represent themselves (which many currently do, with paperwork help from paralegals and targeted legal advice from lawyers). And even if you choose to hire a lawyer to represent you, the proposed rebates will definitely get you started.

Bankruptcy has been around since biblical times, and has long been recognized as an important component of the capitalist economy in that it restores debtors to the consumer marketplace. Specifically, bankruptcy gets rid of credit card and most other kinds of debt (exceptions are alimony and child support; most student loans; recent taxes; and debts caused by fraudulent or willful and malicious actions). Most people are solvent for the first time in years when they emerge from bankruptcy, and once again are able purchase goods and services without going into more debt. Just imagine how the economy would hum if consumers were freed from the punishing interest rates that often creep over 30% for technical violations of credit contracts.

By filing bankruptcy, people will use their government checks to improve their own balance sheet, instead of donating their money to the fat cats who use the large credit corporations to bleed us dry. While it's true that mass bankruptcy filings would tighten rather than loosen consumer credit, it's not a bad idea for us to break our national addiction to debt and learn to pay as we go.

Until this year, people who defaulted on their mortgage would often get an extra kick in the teeth--a tax bill on the difference between what they owed and what the property was finally sold for. With a new federal law, Congress has changed this for the better.

How the old law worked. Prior to 2007, if you owed $300,000 and your home was sold at auction for $250,000, the lender would file an IRS tax form 1099 reporting the $50,000 difference as plain old taxable income to you. Since debt forgiveness just doesn't seem like it should be taxed as income, this practice left many people fuming (or worse). Mercifully, the Internal Revenue Code allowed you to escape the tax if you could prove you were insolvent at the time or if you got rid of the debt in bankruptcy.

The new law. Now, with a few exceptions, Congress has done away with this practice (in a new law, H.R. 3648), effective for the 2007 tax year and the following two years. This means that whatever happens to your home mortgage during that period will not increase your income tax. Whether the law is allowed to sunset after 2009, or whether Congress acts to make it permanent, will probably depend on just how broke the government feels at the time.

What this means: more options for those losing their homes. In past blog posts, I have touted bankruptcy as a good way around the tax issue--since debt discharged in bankruptcy has never been considered to be taxable income. I explained that if you were going to lose your home anyway, bankruptcy was preferable to foreclosure or some of the other remedies such as "short sales"and "deeds in lieu of foreclosure," all of which generated taxable income. Now, if your default is on a mortgage or other debt secured by your home that is used to buy or improve your home, you can choose the best possible course of action without worrying about the tax ramifications. In some cases this will be a short sale, in others a deed in lieu of foreclosure, or if your overall debt situation warrants it, a Chapter 7 or Chapter 13 bankruptcy.

Exceptions to the new law. This tax break doesn't apply to loans for real estate other than your principal residence. If you walk away from a loan on your second home in the country, for example, expect a 1099 in the mail. Similarly, if you take out a home equity loan and take that world trip you've been dreaming of for 50 years rather than use the money to improve your home, you may end up on the wrong side of a tax bill. In both of these situations, bankruptcy will still be an attractive way to avoid income tax liability.

The combination of a downturn in the real estate market and aggressive lending policies has caused millions of homeowners to find themselves in one of these situations:

• You are current on your mortgage payments but your ARM is about to go up and you won't be able to afford payments in the future. You try to renegotiate the ARM but with no luck.


• You have a little equity in your home that you would like to pull out, but you can't get a refinance loan and you are having great difficulty in making your payments.


• You can no longer make your mortgage payments and you are "upside down" on your home--you owe more than the property can be sold for.

The bad news is, in all of these situations you are facing foreclosure. The good news is you may be able to use bankruptcy to delay foreclosure and remain in your home for a year or more without paying one cent on your mortgage. If you are able to save all or a portion of the mortgage payments that come due during this period, you can emerge from bankruptcy with a tidy sum that will help you start over financially. Let's see how this works.

Assume you can no longer afford your mortgage payments or you are upside down on your house. You've accepted the fact that you'll need to find another place to live--but you hope to put if off as long as possible. In California and many other states, you can typically fall three months behind before a statutory foreclosure process begins by your being served with a Notice of Default--which states that your home will be sold after three months if you don't get current or otherwise deal with the problem in that time. This means you can go a total of six months without paying your mortgage before you are faced with the prospect of an involuntary sale of your home (that's three months before the Notice of Default is mailed to you and another three months before the foreclosure sale itself is scheduled). This six months' delay will allow you to save up some money from not paying your mortgage--money that will allow you to rent new quarters.

To buy more time, if, just before the foreclosure sale you file a Chapter 7 bankruptcy, the sale will be stalled while your case is open--roughly three to four months--unless the lender files a request with the court seeking permission to proceed with the sale. Either way, it's safe to assume a Chapter 7 bankruptcy will get you an additional three months delay before you have to leave your house. Another chance to add to the nest egg that will prove useful in adjusting to your new fresh start.

A way to buy even more time is to initially propose a feasible Chapter 13 plan (which requires a steady income that exceeds your expenses by the amount necessary to meet the Chapter 13 repayment requirements) and then convert your case to a Chapter 7 bankruptcy. This will probably delay the foreclosure for at least six months.

And here's the kicker. Even after your home is finally sold at foreclosure, it may just sit there for several more months--with you in it--before the new owner finally gets around to getting you out. If you really want to stay to the bitter end, know that the new owner will have to first serve you with a 30-day "notice to quit" before going to court to obtain an eviction order, and the court eviction process typically takes a couple of months before you absolutely have to move.

But it's not a good idea to have a judicial eviction action on record when you'll be seeking to rent a dwelling--so to be conservative, figure filing for bankruptcy will give you an additional three months of free housing after the foreclosure sale. All together, through a combination of your state's foreclosure laws and federal bankruptcy law, you can live in your home "rent free" for about a year and save up a financial cushion so you won't get into this position again.

To take full advantage of the bankruptcy laws in the manner described here, you will likely need the services of a bankruptcy lawyer. While you can normally file bankruptcy without a lawyer, and you always have the right to do so, a good knowledge of the bankruptcy laws is called for if the primary reason you are filing is to amass a nest egg in the manner I suggest. For example, whether you can keep all of the money you save before you file for Chapter 7 bankruptcy will depend on your state's property protection laws (exemptions). A lawyer is likely to charge a lot for orchestrating this type of strategy--typically between $2,000 and $4,000. However, because you are paying nothing for your shelter for up to a year, it may be worth your while, and you'll probably gain more time in your home than if you do it yourself.

To find out more about attempting to save for retirement while simultaneously trying to get out of debt, try reading Solve Your Money Troubles: Get Debt Collectors Off Your Back & Regain Financial Freedom, by Attorney Robin Leonard (Nolo).