Foreclosure vs. Bankruptcy: Which one is better?

I recently ran across a question on a legal forum in which a person asked "why should I file for bankruptcy when my house is in foreclosure and that is my only debt?" She clarified that she had consulted a lawyer and he told her that foreclosure and bankruptcy led to the same result and that she should not bother with a bankruptcy filing.

This is the worst advice this woman could have been given! There is a world of difference between bankruptcy and foreclosure.

Let me explain the differences between foreclosure and bankruptcy.

FORECLOSURE

In a typical foreclosure situation, a person has lost the ability to pay their mortgage so the bank takes the most obvious measure to protect their investment, foreclosure. A foreclosure lawsuit results in the bank taking back the property and the owner stops paying the mortgage. If the bank simply stopped after taking back the property then there would be no need for this blog post; the bank does not stop after taking back the property, they will sue you for the deficiency. The real estate market in which we presently find ourselves is unprecedented with homes being valued at less than the amount owed on them which causes a deficiency when they are sold. For example, if you own a home with a $1,000,000 mortgage on it and you miss mortgage payments resulting in a foreclosure suit, the bank will take possession of the home and sell it at a foreclosure sale. At the foreclosure sale, the home sells for $450,000, the bank takes the $450,000 and applies it to the $1,000,000 mortgage. The bank is still owed $550,000 on the original morgage agreement and will sue you for that amount! This morning, CNNMoney.com reported that the banks will not necessarily sue for the deficiency right away and that in some cases will wait years to do so. This is what happens in a foreclosure suit...not a pleasant result.

BANKRUPTCY

Fortunately for the consumer debtor, the deficiency judgment in a foreclosure is considered "unsecured" credit and is dealt with just as any other credit card debt in bankruptcy! In a Chapter 7 bankruptcy, the deficiency judgment ($550,000 in our example) is completely discharged. In a Chapter 11 or Chapter 13 bankruptcy filing, payments are made on the deficiency over the period of the plan and then discharged.

I hope that this has clarified the difference between letting a home go into foreclosure and filing for banruptcy. If nothing else, keep in mind this mantra: foreclosure is the bank's tool and bankruptcy is yours!