Ch. 13 Debtors Must Pay Mortgage at Default Interest Rate

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May 3 — Chapter 13 debtors who defaulted on their home mortgage loan can’t cure the deficiency by changing the interest rate on their home loan to their pre-default interest rate, the U.S. Court of Appeals for the Fourth Circuit held April 27.

Judge James H. Wilkinson III agreed with the courts below that the cure lies in decelerating the loan and allowing the debtors to avoid foreclosure by continuing to make payments under the contractually agreed upon rate of interest.

The court rejected the debtors' attempt to modify the terms of their home mortgage loan. According to the appeals court, post-petition payments should reflect the parties' agreed upon default rate of interest — 7 percent.

The appeals court affirmed insofar as post-petition interest payments should be calculated using the 7 percent default interest rate, but reversed the part of the judgment which applied a 5 percent interest rate to payments calculated for the period between Sept. 16, 2013 and Dec. 2013, the effective date of the plan. Payments after the effective date of the Chapter 13 plan should also reflect a 7 percent interest rate, the court said. “All post-petition interest payments, … should therefore reflect the parties' negotiated seven percent default rate of interest,” the court said, remanding the case to the district court for further proceedings.

Debtors Default on Loan

Debtors William R. Anderson, Jr. and Danni Sue Jernigan purchased a home financed by a $255,000 loan from the appellees Wayne and Tina Hancock. The promissory note required monthly payments of $1,368 based on an interest rate of 5 percent over a 30-year term. In the event of default, however, the debtors' interest rate would increase to 7 percent for the remaining life of the loan until paid in full.

After the debtors failed to make monthly payments, the Hancocks notified them they were in default and that future payments should reflect the increased 7 percent interest rate. The Hancocks then initiated foreclosure proceedings. The debtors filed for Chapter 13 protection, which allows individuals receiving regular income to obtain debt relief while retaining their property, but they must propose a plan that uses future income to repay a portion of their debts over a three to five year period.

The debtors' Chapter 13 plan proposed to pay off prepetition arrears on the loan over a period of 60 months at a 5 percent interest rate. The plan also reinstated the original maturity date of the loan and proposed that the debtors make post-petition payments at a 5 percent interest rate.

The Hancocks objected, contending that post-petition payments should continue to reflect the 7 percent default rate of interest provided for in the promissory note.

No Modifying Creditor's Rights

The bankruptcy court agreed with the Hancocks and held that changing the default interest rate “ran afoul” with Bankruptcy Code Section 1322(b)(2), which prevents plans from “modify[ing]” the rights of creditors whose interests are secured by debtors' principal residences. The bankruptcy court also found that arrears on the loan should be calculated using a 7 percent interest rate for the period extending from June through September 16, 2013.

The debtors appealed, and the district court agreed with the bankruptcy court that setting aside the 7 percent interest rate would be a prohibited modification. The district court, however, disagreed with the bankruptcy court's interpretation of the promissory note. According to the district court, once the Hancocks accelerated the loan, the rate of interest reverted back to 5 percent. In the district court's view, the rate of interest see-sawed depending on whether the loan was in accelerated or decelerated status.

‘Cure' or ‘Modification'?

The debtors appealed to the Fourth Circuit, which agreed with the courts below that the cure lies in decelerating the loan and allowing the debtors to avoid foreclosure by continuing to make payments under the contractual interest rate.

The purpose of Section 1322(b)(2) is “to promote private home ownership by protecting lenders so that they will ‘encourage the flow of capital into the home lending market,'” according to , pt. VII, ch. 229 (D. Michael Lynn et al. eds., 2015).

Plans may also provide for the “curing and waiving of any default” under Section 1322(b)(3). According to the court, the question is whether the plan's proposed change to the debtor's interest rate is part of a “cure” permissible under Section 1322(b)(3) and (5), or is a “modification” forbidden by the terms of Section 1322(b)(2).

Impermissible Modification

The Fourth Circuit concluded that turning away from the debtors' contractually agreed upon default interest rate would be an impermissible modification of the terms of the promissory note. The interest rate of a mortgage loan is tied up with the “payments” that a legitimate cure requires must be “maintained,” the court said. The post-petition payments should reflect the parties' agreed upon default rate of 7 percent, the court said.

“Default interest rates allow creditors to adjust upward for increased risk … when the initial risk premium is revealed to have been too low,” the court said. The court also noted that the inability to impose default rates of interest might motivate fewer lenders to engage in mortgage lending.

The court also found that all post-petition interest payments, including those from September 16, 2013 through December 2013, the effective date of the plan, should reflect the parties' negotiated 7 percent default interest rate.

Judge Paul V. Niemeyer and Judge David C. Norton of the U.S. District Court for South Carolina, sitting by designation, joined the opinion.

Cortney I. Walker, and Travis P. Sasser, Sasser Law Firm, Cary, N.C., represented appellants/debtors William R. Anderson, Jr., and Danni Sue Jernigan; Theodore Adelbert Nodell, Jr., Nodell Glass & Haskell, LLP, Raleigh, N.C.; John Fletcher Logan, and Michael B. Burnett, Office of the Chapter 13 Trustee, Raleigh, N.C., for appellees Wayne and Tina Hancock.

To contact the reporter on this story: Diane Davis in Washington at ddavis@bna.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bna.com