Can Chapter 13 Bankruptcy Eliminate Second Mortgages?

Legal stamps – Mortgage deed

Pretty much any house purchased in the last 5 years in the Downriver area of Michigan where our office is located (Taylor, Southgate, Allen Park, etc.) is now worth less than the purchase price. During the real estate purchase boom, a lot of the homes were financed using an 80/20 loan. Basically, the primary mortgage paid for 80% of the purchase price and 20% came in the form of a home equity line of credit (HELOC) or a second mortgage. This is how many purchasers were able to buy their new home with little to no money down.

Well, those days have come to an end and many homeowners after this great recession are now making payments on a house that is worth less than what is owed. Some of these second mortgages had a flexible interest rate which has gone up and the payments made on it are mostly, if not entirely, interest. This is discouraging to say the least if not outright depressing. Many clients who fell into this finance trap with increasing home ownership costs and decreasing income find themselves considering bankruptcy as a smart option to restructure their finances and eliminate their debt.

Chapter 13 provides an option to modify your second mortgage that is not available in a Chapter 7. The general rule in bankruptcy is that secured liens will survive a discharge even if the obligation on the note is discharged. However, if you can show that the second mortgage is wholly unsecured you can strip the lien from the house once you complete your Chapter 13 plan payment.

Here is an example. Your house is appraised and has a fair market value of $125,000. The first mortgage has a principal balance of $140,000. The second mortgage is $25,000. Since the house is worth less than the first mortgage, the second mortgage is unsecured by any equity. When the bankruptcy is filed, a lawsuit is filed against the mortgage company to remove the secured lien and make it an unsecured debt like a credit card. This type of lien strip is only available in a Chapter 13.

Unfortunately, many of our clients think that because we can modify the second mortgage, the bankruptcy code allows them modify the terms of the first mortgage. Despite some efforts in Congress to allow this, as of right now, the Bankruptcy Code does not allow any mortgage modifications to the primary mortgage of your principal residence. Some proposed legislation has been discussed which would give bankruptcy judges the power to do this but it hasn’t gone anywhere. Until that does happen, there is still a lot of benefit to keeping your house and stripping any unsecured lien as part of the plan.

Christopher McAvoy is a Michigan attorney and consumer bankruptcy lawyer who helps people file Chapter 7 and Chapter 13 bankruptcy. To find out more about bankruptcy, read The Bankruptcy Book.

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