Benefit of Chapter 13 Bankruptcy

Underwater House? Lien Strip

Without getting into the different distinctions of bankruptcy chapters (Chapter 7 and Chapter 13 for consumer debtors) and the complexities of dischargeability (or wiping out liability on debt), I wanted to focus on one positive aspect of the bankruptcy code which, due to the housing market crash has provided debtors filing a chapter 13 bankruptcy to void the “home equity line of credit” or the 2nd and 3rd mortgage when the value of the home is undersecured by the first mortgage. This means that if your home is worth less than what you owe on your first mortgage, the Bankruptcy Court can void any other liens on your residence that do not have priority. This has come to be known as “lien stripping” because the Court “strips” the lien, or security interest, on the property.

Stripping a Mortgage Lien

Section 506(a) of the Bankruptcy Code allows for this action. The Code says that a creditor’s claim on property is a secured claim up to the point of value of the debtor’s property, otherwise, the claim is unsecured. This is important because in bankruptcy, generally a debtor’s secured creditors get paid and the unsecured creditors get paid very little or nothing at all.

There are a couple of issues to handle before a court will void a home owner’s liability.

Only For Chapter 13 Debtors

First, only chapter 13 debtors are able to receive this benefit. While Section 506(a) details what is and isn’t a secured claim, Section 1322(b)(2) gives the Debtor the ability to modify the rights of secured claims. There is no provision in Chapter 7 that would allow lien stripping on a residence such as this. (Although there is a split decision in New York Bankruptcy Court on whether a Chapter 7 Debtor can strip a second mortgage).

Only Wholly Unsecured Mortgages

Second, the second mortgage must be “wholly unsecured”, meaning no part of the mortgage can be secured by the value of the property. For example, if your home is worth $100,000 and you have a first mortgage balance of $95,000 and a second mortgage balance of $10,000, the Court would not be able to void the second mortgage because it is not “wholly unsecured”. In our example, $5,000 of the loan is secured by the value of the property. Now if your home was valued at $90,000 and you owed $95,000 on your first mortgage and $10,000 on your second, the second mortgage is wholly unsecured. No portion of the value of your home secures the second mortgage. It can be stripped. 

Note in the above example that the home was undersecured by the first mortgage, meaning the value of the home is even less than what is owed on the first mortgage. The Bankruptcy Code states that the unsecured portion of the first mortgage cannot be wiped away or stripped from the mortgage. There was a proposal in Congress to allow “cram-down” of mortgage loans such that a Bankruptcy Judge would be authorized to wipe out the unsecured portion of a first mortgage. That proposal failed, but we could likely see it pop back up again if the home foreclosure rate continues to skyrocket.

Must Successfully Complete Chapter 13 Plan Payments

Lastly, while you can strip the second mortgage in chapter 13, you must complete your bankruptcy plan successfully and receive a discharge of debts. If your chapter 13 bankruptcy is dismissed for whatever reason, the loan is not stripped and you would still be responsible for it.

Lien Stripping Process in Nebraska

In Nebraska, the process is quite simple. As your Omaha Bankruptcy Attorney, we can file what is called an Adversary Proceeding to void your second mortgage. We request that you get a professional home appraisal completed that will be used to establish that your home is worth less than your first mortgage and thus your second mortgage is “wholly unsecured” and should be avoided.

In certain circumstances, it may be in your best interests to file for chapter 13 bankruptcy even though you qualify for chapter 7 in order to get rid of a burdensome second mortgage. This will give you a better chance to avoid foreclosure and likely a better scenario is you need to refinance or sell in the future.

Talk with a qualified bankruptcy attorney who understands that sometimes a Chapter 13 bankruptcy filing may be the answer as opposed to Chapter 7 bankruptcy.