Paying Down Mortgage Loan

One option you have for protecting your money before bankruptcy is to put your money into your home, either by making needed repairs or by paying down a mortgage loan.  Depending upon the value of your home and the amount out your mortgage loan, paying down a mortgage loan before bankruptcy could be problematic.  This issue is one of preference.  When you pay any creditor, including your home loan lender, more than an ordinary monthly payment during the 90-day period before you file bankruptcy, the payment could be deemed a preference payment.  A preference means that you preferred one of your creditors over your other creditors. As a general rule, payments to a fully secured creditor are not considered a preference, since a fully secured creditor would be paid in full in a liquidation scenario.

Can I Pay Down My Mortgage Loan Before I File Bankruptcy?

Bankruptcy law restricts your ability to prefer a creditor by making a large payment to them before you file.  More precisely, during the 90-day period prior to your filing, there are restrictions on making more than a regular monthly mortgage payment to your home loan lender. If the payment you made is deemed a preference, the bankruptcy trustee will require your creditor to pay the money back so that the trustee can distribute the money evenly to all of your creditors.  A preference results when payment of a creditor before bankruptcy results in that creditor receiving more than it would receive in a Chapter 7 liquidation scenario. Funds recovered as preferences are distributed pro rata, meaning that each creditor would get an amount equal to the percentage of the total debt that you owe to that creditor.

Fully Secured vs. Partially Unsecured

If you are considering whether to pay down your mortgage loan before bankruptcy the first point to consider is whether the mortgage lender is fully secured versus partially unsecured.  If the mortgage lender is fully secured, meaning that the value of your house is greater than your total mortgage debt, then you can pay down your mortgage loan as much as you like.  But if the mortgage lender is partially unsecured, meaning that you owe more on your house than what it’s worth, then any amounts paid over and above the value of your house are deemed preference payments.

Reason for Different Treatment

The reason for treating secured creditors differently from partially unsecured creditors is based on bankruptcy classification of claims.  In bankruptcy, a creditor’s secured claim is deemed secured only up to the value of the security (your house) and the remaining amount of the claim is deemed unsecured.  This makes good sense because in the event that your mortgage lender was to foreclose on its security (your home), it would only be able to realize the value of the house.

Chapter 7 Liquidation Scenario

Tied directly to the classification of claims and different treatment of fully secured versus partially secured creditors is the Chapter 7 liquidation analysis as applied to preference payments.  More specifically, one of the elements of a preference is that the creditor received more than they would have received in a Chapter 7 liquidation scenario.  In a liquidation scenario, a fully secured mortgage lender would receive full payment on its claim, so no other creditors were affected by the preference payment.  A partially secured lender, would only receive payment up to the amount of its security.  Hence,  preference payments to a partially secured mortgage lender are deemed preferential, to the extent that the mortgage lender receives more than it would have received in a hypothetical Chapter 7 liquidation scenario.  Before making a preferential payment to your mortgage lender, consult with a bankruptcy attorney regarding the consequences and ramifications of making such a payment.

Mortgage May Be Most of Debt

Even if your mortgage is partially unsecured (you owe more on your mortgage than the value of your property), making a preference payment may not be that big an issue.  Even if the Trustee in bankruptcy were to recover the money as a preference, most of  that would likely be repaid back to your mortgage lender, thus paying down your loan.  For example, if you paid down your mortgage loan by $10,000 before bankruptcy and the mortgage loan constitutes 90% of your debt, 90% of the $10,000 would be distributed pro rata to your mortgage lender, meaning $9,000 (less the trustee’s fee for recovering the money) would be paid back to the mortgage lender. However if the mortgage loan constitutes only 50% of your total debt, then only $5,000 would be paid back to the mortgage lender.

Home Loan Preference Result Much Different from Car Loan Preference

The consequence of setting aside a preferential home loan payment is usually much different than when you down or pay off a car loan before bankruptcy.  With car loans, the total debt owed to your car lender is usually a small fraction of your total debt, so the car loan lender receives only a small portion of the preference funds recovered by the trustee, and the remaining funds are essentially wasted, going to your credit card companies and other unsecured creditors.  With home loans, the total debt owed to your mortgage lender is usually a large percentage of your total debt, so your home loan lender receives most of the money recovered as a preference and the setting aside of the preference is a big issue.