A: I think it's important—and fair—that you repay the small loan. You signed those documents in good faith, so it's only right that you take responsibility for what you borrowed. The fact that the lender is charging you 3 percent interest sounds like you're being given an opportunity to make good. Bankruptcy is a very serious process that's meant to address situations in which individuals have no way of meeting their obligations—it isn't an out for when you don't feel like paying up. Besides, bankruptcy laws were tightened in 2005; even if you did file, chances are you would be pushed into Chapter 13, and a judge would probably require you to follow a repayment plan.
The other thing you need to think about is your credit profile. You say that your goal is to eventually buy another home, which you will no doubt need to finance with a mortgage. While the foreclosure on the primary loan is going to remain on your credit report for up to seven years, at least you won't have two of them on your record. Bankruptcy stays on your report up to ten years. There's no formula for determining exactly how much each ding hurts your record, but bankruptcy is worse than foreclosure. Any lender willing to take a risk on you after you've gone bankrupt is going to charge a much higher interest rate than it would for someone with a solid credit score.
Yes, it's hard to write checks for a home you no longer own. But by paying down this lesser amount, you prove that you can handle a new mortgage. Finishing off that loan is the best thing you can do to show future lenders that you can be trusted.