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Bankruptcy can save your home from foreclosure

Homeowners in danger of losing their homes to foreclosure have an unlikely ally: bankruptcy.

That's the conclusion of a 2014 study by the University of North Carolina Center for Community Capital.

According to the study, "Bankruptcy During Foreclosure: Home Preservation Through Chapters 7 and 13," homeowners in foreclosure reduced their chances of losing their homes by 70 percent when they filed for bankruptcy protection.

Mark Lindblad, research director at the UNC Center for Community Capital, and one of the authors of the study, said that bankruptcy has long been a way for homeowners to protect themselves from foreclosure.

"When the bankruptcy laws were first passed, the decision was made that preserving home ownership was a worthwhile way to go," Lindblad says. "That's why the bankruptcy laws do provide provisions that allow owners to keep their homes."

Different types of bankruptcy

Not all bankruptcy filings are created equal. Consumers facing foreclosure can choose from two primary types of bankruptcy filings:

  • Chapter 7
  • Chapter 13

In a Chapter 7 bankruptcy, a bankruptcy court creates a bankruptcy estate from your assets. The money generated by the sale of these assets is used to pay off creditors. Chapter 7 discharges all the debts of a consumer, but most consumers will lose their homes in the process.

Chapter 13 is the most effective

A Chapter 13 bankruptcy results in a debt-repayment plan, giving consumers three to five years to pay back at least some of their debts in the form of affordable monthly payments. At the end of the payment plan, the bankruptcy court generally discharges any remaining debts. During a Chapter 13 bankruptcy, consumers can usually keep their homes.

It's not surprising, then, that Chapter 13 bankruptcy filings were especially effective in avoiding foreclosure, according to the UNC study.

The study said that homeowners who filed Chapter 13 bankruptcy were five times less likely to lose their homes at a foreclosure auction than those who filed for Chapter 7 protection.

How to get a mortgage following bankruptcy

According to Fannie Mae, “The presence of significant derogatory credit events dramatically increases the likelihood of a future default and represents a significantly higher level of default risk.” That’s why mortgage lenders have imposed waiting periods between the time you file for bankruptcy and when you can apply for a mortgage. These waiting periods vary between loan products and which form of bankruptcy you filed for. Be sure to read “How to get a mortgage post-bankruptcy” to learn more.

Bankruptcy is not a cure-all

Nancy Rapoport, Gordon Silver Professor of Law at the University of Nevada, Las Vegas and an expert on bankruptcy law, says that while bankruptcy has long been a way for homeowners to fend off foreclosure, it shouldn't be looked at as a cure-all.

"Banks have to go through more hoops before they can take your home, but that doesn't mean that they can't take it," she says. "It does mean it takes them longer."

Rapoport says the main benefit of a Chapter 13 bankruptcy is that it gives homeowners a chance to catch up with their late mortgage payments.

If struggling homeowners can discharge some of their debts through a bankruptcy filing, they can then devote the money they'd otherwise use to pay those debts into making their mortgage payments, Rapoport says. And this can persuade lenders and banks to scratch foreclosure proceedings.

Banks and lenders usually don't want to take over their borrowers' homes, says Rapoport. They'd rather have the stream of monthly mortgage income.

Bankruptcy: A relatively rare, but effective choice

What surprised Lindblad most was that just 8 percent of homeowners in the study turned to bankruptcy when faced with foreclosure.

That 8 percent figure, though, isn't surprising to Jon Adelstein, a bankruptcy attorney with Adelstein & Kaliner in Doylestown, Pennsylvania. He says that today bankruptcy is a severely underused tool.

"There is a shame of filing right now," Adelstein says. "Too many people would rather go the debt-restructuring route. Too many people don't understand how much protection bankruptcy can give them."

Adelstein says that by discharging some of your debt through bankruptcy, you might be more likely to qualify for a loan modification in the future because of your ability to make lower mortgage payments if you're not as overwhelmed with other debts, he says.

Bankruptcy provides greater power in certain states

According to the UNC study, bankruptcy as a foreclosure-prevention tool is the most effective in non-judicial states, states that do not require the foreclosure process to flow through the court system.

While the study clearly shows the benefits of bankruptcy, bankruptcy isn't for everyone, says Rapoport.  Filing for bankruptcy doesn’t discharge all debts, including student-loan debt, and it does have a long-lasting effect on your credit.

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