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Justin Harelik, the Bankrate.com Bankruptcy AdviserHome equity loan to wipe out bankruptcy?

Dear Bankruptcy Adviser,
Can a person with a Chapter 13 bankruptcy get a home equity loan to get rid of the bankruptcy? Do you know of any banks willing to take the risks? Thank you in advance for your help.
-- Charlotte

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Dear Charlotte,
First, for people who don't know, those under a Chapter 13 bankruptcy are still obligated to pay their debts, but do so under a three- to five-year court-supervised plan. Under Chapter 7 bankruptcies, debts are discharged.

Now, here's something that might surprise you: Even though you're on a Chapter 13 bankruptcy plan, you may be a very attractive person to a mortgage lender. You may be able to emerge from bankruptcy in one fell swoop. There are a few issues, however.

First, traditional mortgages may be difficult to obtain. Some traditional banks have subprime lending divisions and may approve you for a loan. You will need to find a subprime lender to do your refinance (to get a new mortgage). A subprime lender deals with people who have equity in their homes but do not have good credit. These lenders look less at credit and more at the equity in your home and your capacity to pay the mortgage. They also charge more for their services and their loans have higher interest rates than traditional bank loans.

Second, your home is still an asset of your bankruptcy estate. This means that the trustee assigned to your case will be very interested in making sure that your creditors (and the trustee) receive their share of the equity. The trustee will usually insist that all "proofs of claims" are paid off in full, especially if the loan is done during the first 36 months of your plan. A proof of claim is a document filed by a creditor which shows how much money is owed by the debtor in a Chapter 13 repayment plan. Creditors are required to attach evidence of the claim and amounts owed.

Third, you need to make sure you can afford the new mortgage. Many subprime lenders want to get a deal done even at the expense of qualifying you for the loan. You will need a trustworthy accountant or financial expert to let you know whether you truly qualify for the new loan. In fact, a second mortgage may be a viable option, but you must make sure you can comfortably afford the payment. Even though the subprime lender will do the deal, it might be better to stay in the Chapter 13 plan than to take on a loan with a very high rate.

However, if it does appear to be a smart move to refinance with a subprime lender (and an appropriate rate), once you're out of Chapter 13 and a couple years have gone by, you will likely be able to refinance with a traditional bank and get a better loan. You can compare mortgage rates on Bankrate to see what the norm is for "prime" lenders.

Avoid adjustable-rate mortgages, or ARMs. These are loans with an initial "teaser" interest rate that will adjust after a period of time. If interest rates rise, your monthly payment could increase significantly. The loan broker may try to assure you that your credit will improve after two or three years, and therefore recommend an ARM. This is not always true. Sometimes credit scores do not improve as quickly as you would hope.

I have saved many a home by helping a client file Chapter 13 bankruptcy, thereby saving the property from foreclosure, and then working with the client until a trustworthy subprime mortgage lender can refinance the property, then possibly refinancing with a traditional bank down the road.

Warning: Be very wary of working with any lender that offers only a home equity loan to pay off your creditors. The rate is likely to be exorbitant; it might overextend you and risk your property. Trustworthy lenders will offer fixed-rate, first-mortgage options as well as home equity (second mortgage) options. The rate will be higher than the rate from a traditional bank mortgage loan, but the reward of getting out of bankruptcy may be worth it.

Justin Harelik is a practicing attorney in Los Angeles. To ask a question of the Bankruptcy Adviser, go to the "Ask the Experts" page and select "bankruptcy" as the topic.

Bankrate.com's corrections policy-- Posted: Dec. 5, 2006
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