A borrower's Chapter 13 filing stops the foreclosure and replaces it with a five-year plan. Whether that helps or hurts the note depends on what the foreclosure would have recovered.
Value the filing as two outcomes weighted by their probability: a plan that completes, paying the contractual installment plus the arrears over 60 months, and a plan that fails, paying until dismissal and then reaching foreclosure late. On an illustrative underwater first lien, the note is worth $91,346 at a 12 per cent required yield without the filing and $94,537 with it. The filing helps because the plan must pay the full contract; it starts to hurt once the foreclosure would have recovered more than about $112,672.
Worked in full in The Mortgage Note Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
For a note investor, a Chapter 13 notice often arrives shortly before a scheduled foreclosure sale. The automatic stay generally stops the sale, the borrower proposes a plan of three to five years, and the investor's position turns from a recovery into a payment stream with a failure option. Many investors read the filing as bad news. Whether it is depends on two numbers: what the foreclosure would have recovered, and how likely the plan is to complete.
| Input | Value |
|---|---|
| Unpaid principal balance, first lien on the borrower's home | $120,000 |
| Note rate; remaining term | 6.5%; 300 months |
| Arrears at filing, per the proof of claim | $18,000 |
| Property value | $130,000 |
| Net foreclosure recovery without a filing, month 14 | $105,000 |
| Plan length | 60 months |
| Bankruptcy legal costs: proof of claim; motion for relief | $1,500; $1,000 |
| Probability the plan completes | 40% |
| Required yield (annual, compounded monthly) | 12% |
Under section 1322(b)(2) of the Bankruptcy Code, a claim secured only by the debtor's principal residence cannot be modified in Chapter 13: no reduction of principal, rate or term, even when the house is worth less than the debt. The plan can cure the default over its life while the regular payments are maintained, under section 1322(b)(5). So the investor receives two streams:
Contractual payment = 120,000 × i ÷ (1 − (1 + i)−300), with i = 6.5% ÷ 12 = $810.25 a month, resuming from month 2
Arrears cure = 18,000 ÷ 60 = $300.00 a month, paid by the trustee from month 3 to month 62
In Excel: =PMT(6.5%/12, 300, -120000) and =18000/60. The trustee's commission is generally added to the debtor's plan payment rather than deducted from the investor's $300.00, and no interest on the arrears is assumed.
At month 62 the loan is current with a balance of $108,453 and 239 months left. Rather than value 20 more years at 12 per cent, assume the investor sells it as a re-performing note at a 9 per cent yield: $89,920, or 82.9 per cent of the balance. The completed plan is then worth:
Assume the borrower stops paying in month 18. The investor has received $17,464 of payments, files a motion for relief from the stay and completes the foreclosure ten months later, in month 28, for the same $105,000. Present value: $15,885 of payments, $79,468 of recovery, less the legal costs: $93,046. Even failure is worth more than no filing, because 16 months of payments more than pay for a 14-month delay that costs $11,878 of present value on the recovery alone.
| Outcome | Probability | Value at 12% | Yield at a $72,000 price |
|---|---|---|---|
| No filing: foreclosure in month 14 | $91,346 | 32.8% | |
| Plan completes, note sold at month 62 | 40% | $96,773 | 20.1% |
| Plan fails in month 18, foreclosure in month 28 | 60% | $93,046 | 24.4% |
| Chapter 13, probability-weighted | $94,537 |
The filing adds $3,191, 3.5 per cent, to the value of the note. The yield column tells the other half of the story: the investor who bought at $72,000 expecting a 32.8 per cent foreclosure return now earns between 20.1 and 24.4 per cent, because the same dollars arrive over five years instead of fourteen months. Higher value at the required yield and lower IRR are not a contradiction; they are what a longer, still-profitable stream looks like.
| Foreclosure net recovery | Value, no filing | Value, plan fails | Value, Chapter 13 weighted | Effect of the filing |
|---|---|---|---|---|
| $85,000 | $73,947 | $77,909 | $85,455 | +$11,508 (15.6%) |
| $105,000 | $91,346 | $93,046 | $94,537 | +$3,191 (3.5%) |
| $120,000 | $104,396 | $104,398 | $101,348 | −$3,047 (−2.9%) |
| $135,000 | $117,445 | $115,751 | $108,160 | −$9,285 (−7.9%) |
The break-even foreclosure recovery is $112,672, 87 per cent of the property value and 82 per cent of the debt. Below it, the filing is good news: the anti-modification rule forces a borrower with no equity to pay the full contract, which a foreclosure on a thin collateral could never collect. Above it, the filing costs money, because a completed plan converts a near-full, fast recovery into a 6.5 per cent loan valued at 9 per cent, and every month of stay delays a recovery that was already close to the debt.
The completion probability matters less than investors expect. At a $105,000 recovery, the filing adds $2,445 at a 20 per cent completion rate and $4,681 at 80 per cent: the failure branch is already worth more than the foreclosure, so the probability only changes how much more.
The common error is to price the filing as pure delay: push the foreclosure back by the length of the plan and discount. That ignores the payments the plan makes even when it fails, and on an underwater loan it turns a filing that adds value into one that seems to destroy it. The opposite error is to treat a confirmed plan as a re-performing note from day one. A confirmed plan is a promise with a failure option; value both branches. The re-performing branch, once it has seasoned, is valued as in what a re-performing note is worth after 12 months of payments.
Second liens are different. A junior lien with no equity behind it at all can, in most courts, be stripped off in Chapter 13 and treated as unsecured. For a wholly underwater second, the filing is close to a total loss, the opposite of the first-lien case above.
A Chapter 13 filing on a first lien against the borrower's home is a cure, not a write-down. On a thin-equity loan it usually adds value at the investor's required yield, while lowering the IRR; on a well-secured loan it delays a recovery that was nearly whole. Compute the break-even recovery before deciding whether to object to the plan. The book's foreclosure-timeline model, to rerun this note with your own state and dates, is in the free workbook for this case, and the modification alternative is set out in modify or foreclose.
Generally no. A claim secured only by the debtor's principal residence cannot be modified in Chapter 13, so the borrower must cure the arrears and keep paying the contract terms even when the house is worth less than the debt. In the illustrative case the full $18,000 of arrears is paid at $300.00 a month over the 60-month plan, on top of the $810.25 contractual payment.
The automatic stay generally stops it on the filing date, although repeat filers may get a shorter stay or none. The investor files a proof of claim for the arrears and receives payments under the plan. If the borrower misses post-petition payments, the investor can ask the court for relief from the stay. In the illustrative case a plan failing in month 18 pushes the foreclosure recovery from month 14 to month 28, costing $11,878 of present value at 12 per cent.
It usually lowers the yield but can raise the value. Bought at $72,000, the illustrative note yields 32.8 per cent if foreclosure recovers $105,000 in 14 months, but 20.1 per cent if the plan completes, because the cash is spread over five years. At a 12 per cent required yield the longer stream is still worth more.
This article is one calculation from The Mortgage Note Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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