Usually, when a homeowner finds out that his house has gone up in value beyond his wildest expectations within a few short years, it's good news. But if the homeowner is on the brink of bankruptcy, too much appreciation can be very bad news. Too much equity in a home may eliminate bankruptcy as an option, unless the homeowner is prepared to lose his home in a sale by the bankruptcy trustee.
Home ownership in a bankruptcy context works like this (for those debtors who are current on mortgage payments):
- If the debtor has little or no equity in his house, but is current on payments, then he'll usually keep the house in a chapter 7 bankruptcy (chapter 7 is the typical kind of consumer bankruptcy case which takes a few months to complete). The trustee's job is to liquidate any assets with significant equity to pay creditors, so the trustee has no interest in real estate with no equity.
- If the debtor has substantial equity in his house, if he files under chapter 7, the trustee will be obligated to sell the house to pay the debtor's creditors. In this situation, the debtor will usually file for bankruptcy under chapter 13 (a consumer reorganization case), and make payments to his creditors over a period of 3 to 5 years (not 100% of what they're owed usually, but some percentage determined by several factors, including how much the debtor earns in income). The idea behind this is that the debtor is paying his creditors what they would receive in payments if the case were filed under chapter 7 and the house were sold.
- What happens when a debtor has substantial equity in a house, but doesn't have sufficient income to make payments under a chapter 13 payment plan? He may decide to simply sell the house on his own, use the equity to pay creditors, and then, if significant debts still remain, file under chapter 7.
In recent years, due to the crazed real estate market, many more people have found themselves in this bind. Good luck in the real estate market can translate into very bad luck if you fall upon hard times and have to contemplate filing for bankruptcy.
Until recently, I was not much aware of what life is like for people in the aftermath of financial disaster. I imagined that once the storm has passed, and the bankruptcy discharge has been entered, life goes on as usual. Maybe for a few lucky people who have high incomes (yes, wealthy people end up in bankruptcy too), life can go on as usual, but for the majority of working people, life isn't the same again, ever. They're denied credit for years afterwards because unpaid debt, whether it's reduced to judgment, settled, discharged in bankruptcy, or simply left unpaid, remains on their credit records.
Take my friend Elizabeth*, who is divorced, the mother of a teenage girl, and making ends meet with no support from any outside source. She filed for bankruptcy under chapter 7 a few years ago. Since then, she's lived without credit. While she makes enough income to pay her basic living expenses, she can't buy a house or a car, or get a bank loan to start a small business. To make matters worse, she found out long after her bankruptcy case was closed that a tax debt incurred by her ex-husband is part of her credit record. Recently, she went to a car rental business where she'd rented cars many times before, only this time they ran a credit check and told her she was denied the rental. She was mortified. She wasn't even charging the rental to a credit card (she doesn't have any credit cards), she was paying cash. Luckily, another employee there recognized her from her prior rentals and took care of it. She runs into these situations all the time, never able to take for granted that she'll get respect when she tries to engage in the most ordinary financial transactions.
If you've ever had a credit card charge denied at a restaurant or a store, you know what it feels like when your financial credibility is questioned. You could be having the most pleasant exchange with the person behind the counter when, suddenly, that person looks at you differently, assumes certain things about you. You feel like you're standing there naked, or worse, wearing tattered underwear.
There's very little help out there for people who need to get back on their feet after their credit has been badly damaged. Sure, credit repair services are offered by various companies, but who knows which ones are legitimate. Even under the best of circumstances, it's a very slow and arduous process to fix a poor credit record. Items of history that are legitimately in your record can't easily be done away with. People who've been through financial hard times find that in the modern commercial world, which is not kind to those without "good credit," they are second-class citizens.
*My friend's name is changed to protect her privacy.
Almost everyone who's ever considered filing for bankruptcy wonders how publicy mortifying the experience will be. "Will I have to go to court?" is the way the question is usually stated. People worry that their friends and neighbors, and maybe even their employer, will find out about it.
Normally, in a routine chapter 7 case, you don't go to court. But there is a public proceeding which can feel like going to court. After the case is filed, the court schedules a "meeting of creditors" which is conducted by the trustee appointed to your case. Your creditors are invited to attend and to ask you questions about your debts and assets, though in most consumer cases, creditors don't bother showing up (and when they do, it's not always the ones you'd expect to be there). The trustee asks a series of routine questions about the property listed in your bankruptcy schedules and the nature and extent of your debts (for instance, questions about what you used your credit cards for, whether you have property not shown on your schedules, whether someone has died and left you an inheritance). Occasionally, someone from the U.S. Trustee's office (an arm of the Justice Department), will also show up if there's suspicion that you might be committing "bankruptcy abuse." And all of this takes place in a room full of other debtors and their lawyers, and anyone else who cares to show up, so it is very much a public proceeding. Usually, it's not a horrific experience and, usually (I'm talking about the straightforward, routine chapter 7 case) it lasts just a few minutes, and then you're free to go.
The process is demoralizing enough that no one would do it just for kicks, contrary to the belief held by many that hordes of people go around charging up their credit cards with the knowledge that they can easily turn around and get rid of the debt through bankruptcy.
It ain't easy, and it's only going to get harder. In the jurisdictions where I practice, consumer bankruptcy lawyers typically charge $600 to $1,000 for a "simple" chapter 7 bankruptcy case (many cases turn out not to be simple). That covers the initial meeting with the client, preparation and filing of the petition, schedules, and statement of financial affairs, appearance at the mandatory meeting of creditors, and responding to inquiries from creditors. If a lawyer charged on an hourly basis for "simple" chapter 7 cases, a single case would often result in legal fees of $2,000 or more. Big firms don't represent consumers because they take a loss on each case (considering they commonly charge hourly rates between $300 to $500 or more for an experienced attorney). Small firms that specialize in consumer bankruptcy can profit only if they have a high volume of cases, with most of the work being handled by paralegals and secretaries. So, if the pending bankruptcy reform legislation -- which promises to make the whole consumer bankruptcy process alot more complicated -- becomes law, there will be a crisis in this profession. Lawyers who specialize in consumer cases will have to either charge more (in which case many consumers simply will not be able to afford bankruptcy protection) or switch to a different practice area. With consumer bankruptcy lawyers out of the way, ruthless credit card companies and the vultures that dominate the credit counseling industry will have a field day.
It's a matter of attitude. It's not uncommon for an individual who owns a business that goes bankrupt to file for personal bankruptcy as well. The reason is simple -- many business owners guarantee the debts of their businesses, and when their businesses go belly-up, the creditors come after the guarantors. But, unlike many personal filers who have little experience running corporations, an individual who is a business owner often has a different approach to his personal finances. He thinks of his own money and debts in much the same way as he thinks of his business finances -- with objectivity. Every business is a gamble, and banks that lend money to businesses partake of the risk in a cool-headed fashion. And here's the thing, when a bank lends money to an individual, it does so with the same objectivity and assessment of risk employed when lending money to a business. The point I'm making here is that as a society we accept that businesses fail for reasons that have nothing to do with morality. At the same time, many people who find themselves in financial straits and heading towards bankruptcy feel the sting of moral judgment. The reason why business-savvy people suffer far less from this stigma is that they understand the way money works and the way the credit industry works, and are much less susceptible to the psychological manipulation that keeps many decent, hard-working people enslaved to their debt when they don't have to be, even when they've been victimized by predatory lenders.