Debtors in Chapter 13 bankruptcies are often burdened by more than one loan on a single home, and it’s not uncommon for the house itself to be worth less than what you owe (an unfortunate situation known as being “underwater”). Although it sounds almost too good to be true, bankruptcy law gives you a way to rid yourself of a junior mortgage—and still keep that house. Debtors do this by filing a “lien stripping” motion in bankruptcy court. Once granted, you stand to save thousands of dollars, because after you complete your repayment plan, the balance of the junior loan(s) will go away.
A successful lien stripping motion works by transforming a junior mortgage from a debt that survives your bankruptcy, called a “secured debt,” into an “unsecured debt”—a debt that gets discharged (wiped out) at the end of your bankruptcy. To understand how this works, you’ll need to understand how the two types of claims are paid in bankruptcy.
When you apply for a home loan, you agree to give the lender a “lien” or “security interest” in the property. The lien allows the lender to foreclose if you stop making payments. To keep your house, you must stay current both during and after your Chapter 13 case because you remain responsible for the outstanding mortgage balance until it’s paid. (Find out more about secured debt in Secured Claims and Liens in Bankruptcy.)
Unlike secured debt, you aren’t required to fully pay nonpriority unsecured claims (credit card bills, medical bills) in your bankruptcy. In fact, unsecured creditors rarely get much at all. They wait in the back of the line until your secured debt, priority claims (unpaid taxes, family support obligations), and living expenses get paid, and then make do with what’s left over, called your “disposable income.” It’s not unusual for unsecured creditors to recover a mere fraction of the original balance. Better yet, after you complete your repayment plan, any remaining balance gets wiped out (discharged). That’s right—the balance goes away.
It’s easy to see why converting a secured junior mortgage to unsecured debt makes financial sense. If successful, a junior mortgage will go away with your other unsecured debts. Read on to find out how you can work this magic.
Successful lien stripping in a Chapter 13 bankruptcy involves two essential components: You must prevail on a lien stripping motion, and you must finish your repayment plan. Here are more specifics on each requirement.
To strip a lien, you’ll file a motion in bankruptcy court, asking the judge to reach two conclusions regarding the value of your house:
If you’re successful, the judge will declare the junior loan “unsecured” and instruct the bankruptcy trustee—the person in charge of paying your creditors—to pay the junior mortgage as an unsecured debt instead of a secured debt. In other words, the junior mortgage holder will get paid, if at all, out of the pot of money available to all unsecured creditors in your bankruptcy.
Here are some examples of how it works.
Example 1. You owe $115,000 on your first mortgage and $30,000 on your second mortgage. Your property has dropped in value since you purchased it, and now it’s worth only $100,000. Because your property is worth less than the first mortgage and there is no property value left to cover any part of the second mortgage, the second is considered unsecured and can be stripped off in a Chapter 13 bankruptcy.
Example 2. You owe $145,000 on your first mortgage, $30,000 on a second mortgage and $15,000 on a third mortgage. The property is valued at $125,000. You can avoid both your second and third mortgages in a Chapter 13 bankruptcy.
Example 3. You owe $100,000 on your first mortgage, $20,000 on your second mortgage and $10,000 on your third mortgage. Your property is now worth $115,000. The value of the property will cover your first mortgage and at least a part of your second mortgage. The third mortgage, however, is completely unsecured. You can strip off the third mortgage in a Chapter 13 bankruptcy.
The second requirement for a successful lien stripping maneuver is that you must finish your repayment plan. If you miss your payments while the plan is in force, the court will dismiss your case and the lien will stay in force, attached to the property until you repay the loan. You’ll receive credit for the amount paid on your account during your bankruptcy, but nothing more.
If you file for Chapter 7 bankruptcy and want to keep your house, you must repay all loans secured by the house, even if one of the loans is underwater. Until recently, some bankruptcy jurisdictions took a different view. However, in 2015, the United States Supreme Court decided Bank of America v. Caulkett, holding that a Chapter 7 bankruptcy filer can’t strip off the lien of a junior mortgage holder on property that is the debtor’s principal residence. The Court based its decision, at least in part, on a prior case that prohibits a bankruptcy filer from altering the terms of a mortgage loan on residential real property.
The Caulkett case applies only to Chapter 7 bankruptcy cases. In Chapter 13 bankruptcy cases, you can still strip the liens from junior mortgages
Avoiding a junior lien requires that you present expert testimony at an evidentiary hearing about the value of your house. Because of the complicated nature of lien stripping, it’s always a good idea to consult with a bankruptcy attorney.
