Foreclosure or Bankruptcy, What’s Worse?
An overview of foreclosure, bankruptcy, and their consequences.
As the national foreclosure rate continues to rise, I’ve had several people ask me how it differs from bankruptcy. In this episode I’ll give you an overview of both legal processes and how they can affect your financial future.
You’re probably aware that foreclosure is the final option that a lender has when a borrower doesn’t pay their loan. It's a forced sale of the real estate that secures a loan. The proceeds of the sale allow the lender to recover all or a portion of the amount they’re owed by the borrower.
The Basic Foreclosure Process
The foreclosure process varies from state to state. I’ll put a link in the show notes where you can compare the state specific foreclosure laws. But when property is said to "be in foreclosure" this means that the owner's lender has begun the legal process to force the sale of the property. It starts once the lender files a public notice in the county records, called a Notice of Default or Lis Pendens. This puts everyone on notice that the borrower is facing foreclosure. If payments are not submitted to make the loan current, the lender’s next step is to announce the date of the foreclosure sale by filing a Notice of Sale.
The foreclosure sale is actually an auction that normally takes place on the steps of the county courthouse. The opening bid for the property is usually set by the foreclosing lender. If no one bids higher than the lender, they take ownership. Once a lender or bank owns a foreclosed property it’s called a Real Estate Owned or REO property.
The law allows a homeowner every opportunity to stop the foreclosure process. The borrower can make the loan current or sell the property at any time, right up to the minute the auctioneer says, “Sold”. In many states there’s even a period AFTER the foreclosure sale during which the borrower can get the property back with full payment. This is called a statutory right of redemption.
Ways to Avoid Foreclosure
If your debt problem is due to the fact that your house payment is too high for your income, consider these five solutions to avoid foreclosure:
If your financial shortfall is temporary due to a job loss, for example, as soon as you’re back on your feet your lender may agree to a repayment plan. This would slowly get you caught up on all missed payments, while you continue to make the regular monthly payments.
Negotiate a loan modification plan with the lender for a lower interest rate and/or longer payback term to lower the monthly payments.
Request forbearance, or a temporary suspension of payments, with the lender.
Request the lender take a “deed in lieu of foreclosure”. This means giving the property to the lender and walking away debt free. This may be attractive to a lender if the cost of foreclosure would be greater than their equity loss on the house.
Sell the house and pay off as much of the loan as possible. If your loan amount exceeds the sale price, this is called a short sale.
Not only does foreclosure remain on a credit report for up to seven years, but it can trigger some nasty tax consequences. This happens when the sale proceeds at auction or from a short sale are less than what’s owed on the delinquent loan. The difference is considered taxable income in certain situations. And when the sale doesn’t cover the full debt, in many states the lender can file a deficiency judgment and sue the borrower for their loss. All these bad consequences to foreclosure may leave you thinking that bankruptcy would be a better option…
Personal Bankruptcy Options
Bankruptcy is a legal process that’s completely separate from foreclosure. There are strict requirements to qualify for financial relief under any type of bankruptcy. Filing is a complex process that costs money and usually requires the guidance of a specialized attorney. The most common types of bankruptcy for individuals are Chapter 7 and Chapter 13.
Chapter 7 involves liquidation, which means that a court-appointed trustee takes over your non-exempt possessions to sell them or give them to creditors. This discharges unsecured debt but does not erase things like judgements, tax bills, child support, or secured debts such as home loans. So Chapter 7 bankruptcy will not stop a foreclosure sale. It is the best option for people with little property but a lot of unsecured debt such as credit cards or medical bills. Chapter 7 stays on a credit report for ten years.
A Chapter 13 filing is known as a wage earner’s plan or a debt adjustment bankruptcy. It requires a regular source of income to pay debts over time to a trustee following a court-approved repayment plan. This delays and reduces payments to all creditors, including home lenders. So Chapter 13 can stop foreclosure as long as the agreed upon payment plan is honored. It will stay on a credit report for seven years.
Which is Worse?
There’s no simple answer for which option is best… or should I say the least worst? To choose between foreclosure and bankruptcy is like choosing between a root canal and open heart surgery! They’re both going to be uncomfortable, but are options of last resort to put a debtor on the road to financial recovery.
[[AdMiddle]If you’re a homeowner in default on your home loan, you’ll first need to decide whether you want to try to keep your home. If you do, communicate with your lender as early as possible about every option they’re willing to consider. But if reducing your monthly payment, or even eliminating it all together through foreclosure or a short sale, would still leave you in a dire financial condition, consider discussing your eligibility for bankruptcy with an attorney and a qualified credit counselor.
For information about mortgage short sales, check out this previous episode of Money Girl.
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