If I file Chapter 7 or Chapter 13 bankruptcy, how will that affect my mortgage?

Written by Northwest Mortgage

Published on Tue, Jul 19, 2022, Last Updated on Tue, Jul 19, 2022

If I file Chapter 7 or Chapter 13 bankruptcy, how will that affect my mortgage?

Do you have questions about personal bankruptcy and how filing will affect your mortgage application? You’ve come to the right place - today, we’re talking about the two most common types of bankruptcy and how they might affect what loans you can get for a mortgage.

But first: what is bankruptcy?

A primer on bankruptcy

Bankruptcy refers to a legal proceeding that involves a person who cannot repay their debts. The person files a petition for bankruptcy, then the court assesses the person’s assets and determines which ones can be used to pay off some of the outstanding debt. Bankruptcy proceedings give people filing a chance to be free from debt while also allowing creditors a chance to get repayment or partial payment on debt.

In the USA, there are 6 “chapters” of bankruptcy, but we’re going to focus on two: Chapter 7 and Chapter 13. These two chapters are for personal bankruptcy, meaning an individual can file for this kind of bankruptcy (as opposed to municipal bankruptcy, bankruptcy for farming/fishing operations, bankruptcy for entities in multiple countries, etc).

As we go into more detail about Chapter 7 and Chapter 13, keep these definitions in mind:

  • The “debtor” is the person going through bankruptcy court.
  • The “creditors” are the people hounding the debtor to pay them.
  • Having a debt “discharged” means the debtor is no longer legally required to pay that debt, permanently - meaning, they are free from paying that money to the creditor.

Chapter 7 bankruptcy

Chapter 7 bankruptcy is “liquidation” bankruptcy - basically, the court determines if the debtor is eligible to file under Chapter 7. If so, the debtor provides the bankruptcy court with a list of creditors and a lot of other documents about their financial situation. Then, a court-appointed bankruptcy trustee sells the debtor’s assets and uses the proceeds to pay creditors in accordance with that list of creditors. If there aren’t any assets of any value that can be sold, then the court determines that bankruptcy to be a “no-asset” case. Bankruptcy code allows the debtor to keep certain “exempt” assets, which change based on applicable state law.

Immediately after a debtor files under Chapter 7 bankruptcy, the court issues a “stay” that prevents most creditors from taking further action to collect from the debtor (lawsuits, threatening calls, garnishments, etc.). This “stay” can be permanent or temporary; however, as long as that stay is in effect, creditors cannot take action against the debtor. However, action CAN be taken against co-signers for any debt.

Once the Chapter 7 bankruptcy filing is finished (sometimes as soon as four to six months after filing), most of the debtor’s debts will be discharged. Certain kinds of debts, such as alimony, child support, student loans, debts owed by many kinds of lawsuits (malicious destruction of property, personal injury, etc.), cannot be discharged during Chapter 7 proceedings.

Other than these kinds of debt, debtors receive a “fresh start”, but the bankruptcy filing stays on their credit report for up to 10 years after the discharges are issued.

Chapter 13 bankruptcy

Chapter 13 bankruptcy is called “reorganization” bankruptcy or a “wage earner’s plan”. Debtors with a regular income to restructure their debt and create a plan that repays all or part of their outstanding debts over a period of three to five years (typically). The debtor makes payments to a Chapter 13 trustee, who then distributes the payments to creditors.

Like Chapter 7 bankruptcy, Chapter 13 ensures that creditors have no contact with debtors while the bankruptcy is proceeding. And at the end of the payment plan, any eligible debt that’s outstanding is discharged.

As opposed to Chapter 7 bankruptcy, which liquidates all assets, this type of bankruptcy allows debtors to keep some of their property (such as a house or car) while they repay their debts. Most notably, filing for Chapter 13 bankruptcy halts the foreclosure process and allows individuals to keep their homes and can help them make up for late payments over a period of time. In addition, Chapter 13 can also protect co-signers on certain debts as well. Once the debt has been discharged, Chapter 13 bankruptcy will stay on your credit report for seven years.

How does bankruptcy affect my mortgage?

It’s not impossible to get a mortgage loan post-bankruptcy - far from it. But a bankruptcy status on your credit report does impact what kinds of loans you can get and when you can get them.

As expected, bankruptcy significantly lowers your credit scores on all 3 major credit reports and cannot be removed for a specific period of time (10 years for Chapter 7, 7 years for Chapter 13). However, according to Experian (one of the 3 major credit reporting agencies), “its impact lessens over time.”

Since the impact lessens, you should use that time to build back your credit in other ways, such as making on-time payments for new credit (such as secured credit cards or smaller loans), keeping up with non-bankruptcy account payments, becoming a cosigner, and explicitly asking creditors to report your activity to the credit reporting agencies.

Typically, it’s difficult to get a mortgage until your debts have been discharged (meaning, the bankruptcy proceeding is completely over). Makes sense, since you’re convincing a court that you don’t have money and buying a house takes… well… a significant amount of money.

In addition, seeing a bankruptcy filing, even if it’s been discharged, could make banks more hesitant to loan to you. A bankruptcy filing, to lenders, indicates a significant financial risk. While they may choose to lend money to you, you might expect much higher interest rates and might need a much larger down payment (especially if you’re buying a house).

However, if you’ve filed bankruptcy and have received your discharge or dismissal date, KEEP THAT DATE. Keep that documentation handy because many, many loans require a “waiting period” of a varying number of years from that discharge date before you’ll be able to apply. The chapter of bankruptcy you applied for will also determine how long that waiting period is.

Here are a few types of loans, listed by Experian, that are available for individuals who have completed bankruptcy proceedings:

  • Conventional loans - expect stricter requirements (good credit score, needing larger down payment (up to 20%), or need private mortgage insurance). 4 years from discharge date (Ch. 7), 2 years from discharge date OR 4 years from dismissal date (Ch. 13)
  • Federal Housing Administration (FHA) loans - 2 years from discharge date (Ch. 7), 1 year from discharge date (Ch. 13)
  • USDA loans - aimed at rural borrowers with a certain income. 3 years from discharge date (Ch. 7), 1 year from discharge date (Ch. 13)
  • Veterans Affairs (VA) loans - available only to those who have served or are serving in the military. Doesn’t require down payments or private mortgage insurance AND gets a low interest rate; however, requires a funding fee which is a percentage of the home’s price. 2 years from discharge date (Ch. 7), 1 year from discharge date (Ch. 13).

If you’re struggling to get a mortgage after a bankruptcy filing, contact us - we believe good people get into bad situations, and we’re not here to judge you or treat you like a second-class citizen (like some lenders might imply). We’re just here with solutions to your mortgage needs post-bankruptcy.


Sources:

https://www.investopedia.com/terms/b/bankruptcy.asp

https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-7-bankruptcy-basics

https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-13-bankruptcy-basics

https://www.forbes.com/advisor/debt-relief/types-of-bankruptcies/

https://www.debt.org/bankruptcy/types/

https://www.experian.com/blogs/ask-experian/can-i-get-a-mortgage-after-bankruptcy/


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