Can a Home Equity Loan be Used to Escape Bankruptcy?

Over at Bankrate.com, The Bankruptcy Advisor was recently faced with this question:

• 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?

First, for people who don’t know, those under a Chapter 13 bankruptcy are still obligated to pay their debts, but they do so under a three- to five-year court-supervised plan.

Now, here’s something that might surprise readers: Even though you’re on a Chapter 13 bankruptcy plan, you may be a very attractive candidate to a mortgage lender. There are a few issues, however.

First, traditional mortgages may be difficult to obtain; you’ll probably need to find a subprime lender to do your mortgage refinancing.

A subprime lender deals with people who have equity in their homes, but lack good credit. Such lenders look less at credit and more at the equity in your property, along with your capacity to pay the mortgage. They also charge more for their services, while their loans have higher mortgage 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.

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’ll 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.

In this situation, 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.

Warning: Be very wary of working with any lender that offers only home equity loans 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.