Can a Loan Modification Help you Avoid Bankruptcy

by tammy on June 4, 2010

Since the collapse of the U.S. residential real estate market in 2008, many Americans have found themselves facing some sort of serious financial hardship. Record numbers of Americans have filed for bankruptcy and many others have found themselves having difficulty making their monthly mortgage payment. These hardships frequently include variable mortgage rates that have increased significantly, a dramatic decrease in household income (often through unemployment), or some sort of temporary hardship like a medical emergency. In many of these instances, people having trouble making their mortgage payments have looked into loan modification as an alternative to default and foreclosure.

The overall purpose of loan modification is to reduce the amount of the monthly mortgage payments to a more manageable level. The basic standard – as formulated by the federal government’s Home Affordable Modification Program (HAMP), the federal loan modification plan – is that a mortgage payment should amount to more than thirty-one percent of the home owner’s gross (not net) monthly income. So, for a household making $7,000 per month in gross income (before bills), their mortgage payment should not be more than $2,170 per month. Based upon this standard, most lenders will not even consider a loan modification if the homeowner is already paying thirty-one percent or less of their monthly gross income in mortgage payments.

Further, a loan modification usually works to the lender’s disadvantage, meaning either they get less money than originally agreed, or – more commonly – they still get the same amount of money, but they get it over a longer period of time. This means that lender’s generally view any loan modification proposals negatively and will not even consider a loan modification unless the borrower can comprehensively document their financial hardship AND the lender determines that foreclosure would be a worse option than modification. This means that basically for a loan modification proposal to even get off the ground the borrower has to be in serious danger of default already; in which case bankruptcy might actually be a better option than efforts at loan modification since a person’s home is typically exempted from liquidation in Chapter 7 bankruptcy.

In order for a lender to agree to a loan modification, the borrower has to have means to continue making significant, even if reduced, payments on the mortgage. This runs up against the means test that was implemented for filing bankruptcy through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Basically, if you have the means to make monthly payments under a loan modification agreement that any lender would agree to, then you probably make too much money to file for bankruptcy anyway. Conversely, if you qualify for bankruptcy, then you probably don’t have enough money to meet your obligations under any sort of loan modification arrangement.

Finally, there is simply the fact that Chapter 7 bankruptcy does not offer any permanent relief for secured debts – like mortgages – anyway. That is, Chapter 7 bankruptcy may temporarily stall foreclosure proceedings, it can not discharge the debt owed on a mortgage, so the lender still owes the money. In fact, for a borrower that might qualify for a loan modification agreement; filing for Chapter 13 bankruptcy might be a better option altogether. Though it will wreck the borrower’s credit, it will protect his home from foreclosure while instituting a court order debt restructuring plan that is very likely to reduce the monthly mortgage payment well below the amount that any lender would voluntarily agree to.

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