How Does Bankruptcy Affect Loan Modifications?
Loan modification is the process of changing the terms of a major loan in some way so borrowers can avoid late payments and the possibility of default. In the case of a mortgage, default can mean foreclosure and serious credit damage. Among the options borrowers have to avoid default are bankruptcy and loan modification. Some borrowers may attempt to modify the loan while filing for bankruptcy. How the two work together depends on the type of modification and bankruptcy.
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Loan Modification Types
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Lenders may consider several types of loan modification. When a bankruptcy is involved, the change usually involves terms of payment, Often the length of the mortgage is altered to allow the borrower to make smaller monthly payments. Lenders can also effect this change by lowering the interest rate on the loan. Debt settlement is a type of loan modification in which the borrower agrees to pay off some of the remaining balance in a lump sum, and, in exchange, the lender accepts that amount as payment in full.
The two primary types of bankruptcies for individuals are Chapter 7 and Chapter 13. In a Chapter 7 bankruptcy, a debtor's non-exempt assets are liquidated to pay off ceditors, but remaining debts are canceled. A Chapter 13 bankruptcy provides more protection for the debtor's belongings, and it requires the debtor to develop a plan to repay debts over a period of three or five years. Loan modifications typically do not apply in Chapter 7 banskruptcies, but the court sometimes can mandate a loan modification in a Chapter 13 bankruptcy.
Trial Periods
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For many types of loan modification, the borrower enters a trial period to gauge the suitability of the modification. This trial period helps determine whether the modification will provide the borrower the ability to keep up with payments. If the trial period is a success, the modification becomes permanent. If the borrower also files for bankruptcy during the trial period, the modification becomes precarious. The court and lender both must approve the modification for it to continue, and in some cases the loan will revert back to its original structure. If the loan modification has already become permanent, it usually will survive through the bankruptcy.
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Forced Modification
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A forced modification occurs when the court decides to modify the mortgage itself. Bankruptcy courts can require lenders to provide this modification to make the borrower's debts more manageable. The lender rarely can change this modification, but the court only requires a forced modification if the borrower can prove a low level of income relative to his debts. This is common in Chapter 13 bankruptcies, in which the court helps the debtor develop a repayment plan.
NPV Test
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The net value present (NVP) test is a tool lenders use to examine a borrower's finances and help determine whether the borrower is likely to default on the modification. Bankruptcies change the NPV results, but lenders have various standards that affect the influence of NPV. Some lenders consider the constraints applied by bankruptcy as a factor in lowering the borrower's risk. However, others consider that person an increased risk because irresponsible financial activity led to bankruptcy. The latter interpretation makes modification qualification less likely.
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