Stripping a Second Mortgage in a Chapter 13 Bankruptcy

One of current problems in the real estate market is the number of “underwater” mortgages, where the value of the properly has declined below the outstanding value of the mortgage. Banks have been extraordinarily resistant to the concept of loan modifications, where that modification would lower the principal value of the loan and bring it in line with the market value.

Most people are trapped in these houses, as they cannot sell them for a high enough price to allow them to pay off the mortgage. The U.S. Bankruptcy Code generally does not permit the loan value to be lowered or “crammed down” during a bankruptcy to the current market value of the property.

Second Mortgage

If you have a second mortgage or home equity loan, on the other hand, you may be able to discharge this debt through a Chapter 13 bankruptcy if the value of the property has fallen below the outstanding balance on the primary (or first) mortgage.

In this case, the second mortgage holder is no longer a secured creditor, as the property is no longer valuable enough to serve as the security interest the loan was originally based on. In essence, the second mortgage is unsecured, and it is akin to credit card debt. In a Chapter 13 proceeding, the mortgage holder’s lien can be stripped from the estate and they will receive a pro rata share of the amount paid to unsecured creditors. Hence, the term “lien stripping.” For example, if there is a $50,000 second mortgage on the property, the entire lien can be removed for 10 cents on the dollar ($5,000). The homeowner will save $45,000 and can have the remaining amount discharged. They will not have to pay it back.

Valuation

An important factor in this process is having a proper valuation of the property listed in the Chapter 13 plan. A creditor who fails to object to the valuation is bound to it once the plan is confirmed by the court.

Valuation can be a complex issue, often requiring the use of experts. However, with the widespread decline in real estate values, in many circumstances, it should be possible to verify the new value with an appraisal.

Underwater?

If your mortgage is deeply underwater and you have a second mortgage or home equity loan, you should contact an experienced bankruptcy attorney. He or she can review your outstanding loans and advise a strategy to obtain effective debt relief.