A Chapter 7 bankruptcy is a total bankruptcy available to most individuals. Debtors must meet certain requirements regarding their level of income and how much debt they are dealing with, but when used successfully a Chapter 7 can discharge troublesome debts and allow the debtor to start anew. The catch is that the bankruptcy court has the ability to sell off key possessions when conducting the bankruptcy and paying off the more important debts. Mortgages usually survive the Chapter 7 process.
Foreclosures and Affirmations
A bankruptcy does create an automatic stay that freezes the status of other legal actions against the debtor, notably processes like foreclosures. This can help save a house when a mortgage has gone into default. The automatic stay gives the debtor time to "affirm" the mortgage and promise to make loan payments again after the Chapter 7 has been completed. The lender reinstates the mortgage and may restructure the loan to make payments easier.
A mortgage lender has a claim against the debtor's house. The house was used as collateral when creating the loan, so the lender can claim possession of it if payments are missed--this is the basis of the foreclosure process. However, many debtors mistakenly think that a Chapter 7 bankruptcy will wipe away the claim all on its own. Although some parts of the mortgage may be discharged to make the loan current again, the lender's claim or lien against the property will remain, so the lender can still pursue foreclosure once the bankruptcy is over.
Discharging a Mortgage
Sometimes a debtor is tired of dealing with the mortgage and foreclosure process. Because the mortgage is secured by the house, the debt cannot be fully discharged, even in a Chapter 7, but debtors usually have the option to give up the house, transferring the property to the lender. This works much like a deed in lieu of foreclosure and removes the claim the lender has against the borrower, effectively discharging the debt. The debtor loses the house but often on better terms than with a foreclosure.
Chapter 7 bankruptcy can remain on a credit report for up to 10 years and can lower credit scores more than nearly any other negative financial action. This makes it difficult to qualify for a new mortgage after the bankruptcy. Debtors typically find they must wait about two years before lenders will consider making a new loan, and even then interest rates will probably be higher than usual. Debtors should not file for bankruptcy if they want to finance a new home or refinance in the near future.