If you intend to file bankruptcy but are also considering refinancing your mortgage, whether you refinance before or after will depend on a number of factors, including:
- whether you file Chapter 7 or Chapter 13 (learn the difference between Chapter 7 and Chapter 13)
- the state of your credit before you file, and
- whether you have equity in your home.
How Is Your Credit?
If you have good credit before filing bankruptcy, refinancing first might be the best option. However, if your credit is already poor, bankruptcy could actually help you refinance.
If You Have Poor Credit
To refinance a loan, the bank needs to approve your credit. If you're on the verge of bankruptcy because you cannot handle your current debts and you have poor credit, you might not qualify to refinance. Filing either type of bankruptcy can be a benefit in this situation, and so refinancing after bankruptcy if you have bad credit may be helpful.
- A Chapter 7 bankruptcy has the potential to wipe out some or all of your other debts in a very short period of time, which will free up your income to repay the new refinance loan. For example, if you have $30,000 in credit card debt and your monthly payments on those credit cards total $1,000, filing Chapter 7 could wipe out that credit card debt, leaving you with $1,000 extra per month, which a refinancing lender could view favorably. You may need to shop around for a lender that will work with someone with bad credit.
- A Chapter 13 bankruptcy is for those who have regular income and are repaying their other debts on time. Chapter 13 reorganizes your debts, allowing you to pay some debts and not others while potentially reducing interest rates. A Chapter 13 means your debt is reduced, and it shows that you have steady income.
If You Have Good Credit
If you have good credit but need bankruptcy, trying to refinance after bankruptcy will likely result in difficulty. While you will have less overall debt after a bankruptcy, your credit score could take a significant dive, which will affect your ability to obtain a loan. People with good credit do file bankruptcy for various reasons, and if your credit is good, it might be wise to refinance while that is still the case. Individuals with bad credit (including those fresh out of bankruptcy) often receive high interest rates and unfavorable loan terms from nervous lenders.
Example. Bob and Donna have excellent credit, but Bob has been stricken with a very serious and disabling illness and can no longer work. They can afford their house with Donna's income alone, but they know they will no longer be able to keep up with their other debts. They want to refinance the house to get a lower interest rate, but they also want to file bankruptcy to deal with their other debts. They decide to refinance first, since they have good credit and they know the bankruptcy will lower their scores significantly and reduce their chances of getting the loan they need quickly.
Do You Have Equity in Your Home?
If you refinance your home and get money from the refi because you have equity in the property, you are exchanging one type of asset for another -- home equity becomes cash. In bankruptcy, you can exempt different types of property in different amounts. It is usually easier to exempt home equity than it is to exempt cash. For example, federal bankruptcy exemptions allow you to exempt up to $21,625 (as of February 2013) in home equity but only $11,975 (at most) in cash depending on the circumstances. Therefore, if you have equity in your home, waiting to refinance until after you file your bankruptcy may be the wisest course of action.
Example. If your home is worth $120,000 and you only owe $100,000, you have $20,000 in home equity. If you refinance the property for a $120,000 loan, you will suddenly have $20,000 cash. Protecting your property from seizure by the bankruptcy trustee will be easier to do if you leave the equity in the home until after you file your case.
What happens to the money if you refinance before bankruptcy? If you refinance, obtain the money and use it all before you file bankruptcy, the trustee will want to know what you did with it and may ask for proof. Using the money to fix your car, replace appliances, buy braces for your children or pay for any other necessary but unforeseeable expenses is usually acceptable. Using the money to make improvements to the home will increase the home's value, which may make it harder to exempt the home (although, taking out the loan decreased the equity). Using the money to pay off creditors or buy luxury items may come back to bite you.
What happens to the money if you refinance after bankruptcy? If you refinance and obtain the money after you file a Chapter 7, the proceeds are yours as long as the property was fully exempt or the trustee has abandoned it. If you obtain the money after you file a Chapter 13, the proceeds should be yours, because your condition has not improved financially -- you received money, but you also received a loan. Be aware, however, that a Chapter 13 trustee may try to claim the proceeds for your Chapter 13 plan. Further, if you are in a Chapter 13, you must obtain permission from the court before you can take out any loans, including refinancing.
(Learn about other things to consider before you file for bankruptcy in our Prebankruptcy Planning topic area.)