As a Lake Zurich bankruptcy attorney, I am often asked about mortgages as they relate to filing for bankruptcy. The key to understanding how a mortgage is affected in Chapter 7 is to understand the legal mechanisms behind a mortgage.A mortgage is essentially two things. First, a mortgage is a promise to pay the creditor money over a certain amount of time. That promise is similar in nature to the promise to pay on a car loan, credit card, or any other kind of debt. That promise is often called a “promissory obligation.” The promise to pay is a personal obligation, also known as an in personam obligation, which means that the creditor has a remedy against the debtor personally for the debt.
Second, a mortgage is a security interest. A security interest is where the property is put up as collateral for the loan. Security interests are designed to protect the creditor in the event of loan default. A recorded security interest is called a lien. In short, if the loan is not paid, the creditor has a right to take the property, an in rem remedy.
What is the effect of filing Chapter 7 bankruptcy on the promissory obligation and the security interest?The Chapter 7 discharge is very broad, and what it eliminate personal liability by discharging the promissory obligation on the loan. After a Chapter 7 bankruptcy, a creditor loses the right to proceed against the debtor personally, and cannot sue the debtor directly for money.The Chapter 7 discharge is very powerful, but there are limits to its power. Chapter 7 of the bankruptcy code does not have the ability to affect the security interest on a secured debt. In short, a mortgage lien remains intact after a Chapter 7 filing, even though the promissory obligation is eliminated.
Let’s look at an example to see this distinction in action.Example 1: Debtors, a married couple, own a single family house with an approximate market value of $150,000. The property is subject to a first mortgage of $110,000 and a second mortgage of $40,000. The debtors then seek bankruptcy advice and file for bankruptcy. If they wish to keep the property, generally all they have to do is continue making their mortgage payments on both mortgages, with a few rare exceptions. Their personal liability on the mortgages is discharged, but the mortgages retain their security interests in the property. If the debtors are current and they wish to keep the property, all they need to do is continue to make their mortgage payments.
If the debtors wish to surrender the property, all they need to do is stop making their mortgage payments. The creditors, with the promissory obligation discharge, still have a right to take the property in foreclosure. The creditor cannot sue the debtors for any deficiency, even after the property is sold at foreclosure.
What happens if the debtors pay only the first mortgage? The second mortgage will continue to accumulate interest and late charges if it is not paid, so the $40,000 loan amount will continue to grow. After 12 months of non-payment (assuming an 8% interest rate), the $40,000 loan will grow to $44,000, and after two years of non-payment, it will grow to almost $49,000. At some point, the second mortgage lender may initiate foreclosure proceedings against the property, even if the debtors are current on the first mortgage.Understanding how a mortgage works in Chapter 7 is important so that debtors can make informed decisions about how they wish to proceed in the future. If you are thinking of making a bankruptcy claim, be sure to speak with a qualified bankruptcy attorney in your local area.