(This is part 2 of a three-part series. See part 1.)
This is the second of three articles on how borrowers who anticipate that they soon will be unable to make their mortgage payments can make the best of a bad situation. This article applies to borrowers with significant equity in their homes whose payment problems are caused or aggravated by a heavy burden of non-mortgage debt.
Borrowers in this predicament may be able to extricate themselves by consolidating their non-mortgage debt into a new mortgage. An alternative is consolidation under a Chapter 13 bankruptcy.
The advantage of being your own consolidator is that you stay in charge of your finances, and your credit rating is not materially affected. The disadvantage is that you lose the partial-debt burden relief that a Chapter 13 bankruptcy provides.
Being Your Own Consolidator: When you have equity, you can pay off other debts with cash obtained through a cash-out refinance or a second mortgage. Do it if the prospects for success are good.
Consolidation does not reduce your debt; rather it replaces other types of debt with additional mortgage debt. Consolidation will reduce your required monthly payments, however, because mortgage rates are usually lower than non-mortgage rates, the interest is tax exempt, and the term is probably longer. The critical question is whether your debts will be manageable or not after you consolidate. I have three debt consolidation calculators on my Web site that should help you answer that question.
You must go this route before you fall behind on your payments. If you fall behind, your credit rating will deteriorate and the terms at which you can consolidate will become increasingly onerous. The option of being your own consolidator will disappear very quickly.
Consolidation Under Chapter 13: Under Chapter 13, you are subject to a debt reorganization and payment plan approved by a court. The plan eliminates interest payments and schedules affordable principal payments to eliminate all non-mortgage debts within a three- to five-year period. During this period, you make one monthly payment to a court-assigned trustee, who makes the payments to your various creditors. The creditors are required to accept the plan. When the payment plan has been successfully completed, you are discharged from bankruptcy, but the stain will remain on your credit report for seven years.
If you do go into Chapter 13, any arrears in your mortgage payments will be added to the other debts that are consolidated. This is so even if you are in foreclosure, provided your house has not been sold. Entering Chapter 13 will stop the foreclosure process. Your mortgage balance stays outside of the Chapter 13 process, however, and you continue to be responsible for the regular scheduled mortgage payments.
Refinancing Out of Chapter 13. If you are in Chapter 13 and have substantial equity in your house, the possibility exists of using it to buy yourself out of Chapter 13.
Some lenders consider people in Chapter 13 with equity in their homes excellent loan prospects. While they wouldn’t touch a debtor who was unable to cope before declaring bankruptcy, the same person can become a good prospect by demonstrating a capacity to handle a reduced burden under Chapter 13. Usually, a lender will look for a perfect Chapter 13 payment record of at least a year.
Ordinarily you would not want to accept such an offer if it meant that your required payments under Chapter 13 would rise as a result. This could happen if your mortgage payments were lower after the refinance and if you have not completed your third year in Chapter 13. Speak to your Chapter 13 trustee before considering a refinance.
Assuming a refinance would not affect your Chapter 13 payments, it may or may not pay to wait, depending on the urgency of your need. Lenders, who will limit their loans to 70 or 75 percent of property value when you are in Chapter 13, may go to 100 percent after you are out. Bear in mind, though, that your loan will be classified sub-prime in either case and it will be pricey. To graduate to a higher-quality status and better price, wait another two years after exiting Chapter 13.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
