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Loan terms upheld in bankruptcy

Restoring pre-default interest rate would improperly modify terms

For would-be homeowners struggling to secure a loan, seller financing can be an alternate route into a new house. Like a rent-to-own contract (and controversial precisely for that reason), the buyer gets the keys in exchange for a monthly mortgage payment to the old owners. With no bank playing middleman, the parties are free to handcraft unique terms for what happens if the payments stop flowing—which they might, since seller financing often abets buyers with spotty credit histories.
On April 27, the 4th U.S. Circuit Court of Appeals upheld the terms of one such contract, which provided that the buyers’ interest rate would jump from 5 to 7 percent in the event of a default. The appeals court declined to reinstate the 5 percent rate as part of the borrowers’ bankruptcy plan, holding that this would be a “modification” of the loan barred by bankruptcy law, rather than merely a benign “cure” for the default.
In 2011, William Anderson and Danni Jernigan purchased a home in Raleigh from Wayne and Tina Hancock, financed through a $255,000 loan by the Hancocks. Anderson and Jernigan executed a promissory note requiring monthly payments based on an interest rate of 5 percent over 30 years. The note provided that if Anderson and Jernigan fell more than 30 days behind in payments, they would be in default, at which point the interest rate would jump to 7 percent and the Hancocks would have the right to call in immediate payment of the remaining principal balance.
By 2013, Anderson and Jernigan defaulted and the higher interest rate kicked in. After further missed payments, the Hancocks foreclosed. Anderson and Jernigan filed for Chapter 13 bankruptcy protection, which stayed the foreclosure. As part of their bankruptcy plan, Anderson and Jernigan proposed to pay off the arrears, reinstate the loan’s original maturity date, and resume making payments at the 5 percent rate.
The Hancocks objected, arguing that both the arrears and the post-petition payments should be made at the 7 percent interest rate triggered by the default. The bankruptcy court agreed, and Anderson and Jernigan appealed. After another unfavorable ruling by the district court, the appeals court also agreed that the higher interest rate should remain in effect notwithstanding the bankruptcy protection.
Under federal law, a bankruptcy plan may “cure” any default but may not “modify” any claim secured by the debtor’s principal residence. Unhelpfully, both of these terms are undefined. Cort Walker of the Sasser Law Firm in Cary, North Carolina, argued that restoring the loan terms to pre-default status would fit within the definition of a cure for a Chapter 13 plan—a modification would entail something like proposing an interest rate lower than 5 percent.
But a unanimous Court of Appeals panel disagreed, saying that the bankruptcy plan could cure the default by stopping the foreclosure, but that reinstating the 5 percent interest rate would stretch the meaning of a cure beyond what Congress intended.
“While Congress meant to allow debtors to decelerate and get a second chance at paying their loans, home-mortgagor lenders, performing a valuable social service through their loans, needed special protection against modification, including modifications that would reduce installment payments,” Judge J. Harvie Wilkinson wrote for the court.
The court concluded that default interest rates allow creditors to increase the risk premium they receive in order to account for the higher level of risk suggested by the default. Forbidding lenders from raising interest rates after a default could have negative effects on the market for home mortgages and would upset Congress’ efforts to balance the interests of lenders and borrowers, the court said.
Ted Nodell of Nodell, Glass & Haskell in Raleigh represented the Hancocks. Nodell did not reply to phone calls seeking comments about the decision.
Walker called the decision “unfortunate,” noting that his clients are now paying more than $300 extra per month on their mortgage.
“Our clients are trapped in the default status of the loan even after completing their Chapter 13 case,” Walker said. “It seems to make little sense under the statute that acceleration of the loan, which was just a consequence of default, could be remedied, but the 7 percent interest rate, which was also just a consequence of default, could not be remedied. The opinion is detrimental to individuals who fall on hard times but who can reorganize in Chapter 13 and seek a fresh start.”

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