What are the Options for a Home Mortgage in Bankruptcy: Can I Strip a Second Mortgage in Bankruptcy or Chapter 13?
The answer is that it depends. If you file chapter 7 bankruptcy, you cannot restructure, or “strip”, any mortgage yet the underlying note is still discharged in chapter 7 bankruptcy. However, a discharge of the second mortgage does not mean that the mortgage itself is released and many debtors nevertheless continue to make the regular monthly payments on the discharged second mortgage to avoid foreclosure or to allow for a sale of the home. A discharge of the note merely means that the bank cannot collect against a homeowner personally after the bankruptcy (via a lawsuit or otherwise) yet the bank can still foreclose the collateral or demand payment of the unpaid balance in order for the property to transfer to a buyer. Therefore a chapter 7 discharge offers little benefit to a homeowner, particularly when the second mortgage is at least partially secured by equity in the property beyond the balance owed on the first mortgage.
However there are viable and beneficial options regarding a second home mortgage (or third mortgage or other junior lien) in chapter 13 bankruptcy. There are generally two options in chapter 13 bankruptcy regarding a second mortgage on a homestead property: 1) Lien strip an entirely unsecured second/junior mortgage, or 2) Cramdown the balance of a “short term” mortgage, which essentially bifurcates that mortgage into a secured portion which must be paid off during the life of a chapter 13 plan and an unsecured portion which is dischargeable at the end of the chapter 13 plan. Each option is further explained below.
Option #1: Chapter 13 Lien Strip when 2nd mortgage is entirely unsecured:
If the second mortgage is entirely unsecured—i.e., the balance owed on the first mortgage plus any other senior liens exceeds the value of the home so that there is no equity which secures/collateralizes the second mortgage—this junior mortgage may be stripped from the property. This process is called a “chapter 13 lien strip” and can only be obtained in chapter 13 bankruptcy. A chapter 13 lien strip typically requires that a recent appraisal be done which proves that the value of the house is less than the amount owed on the first mortgage. In Minnesota, a motion to determine value of the secured claim must be filed in the bankruptcy court shortly after the chapter 13 case is filed. The mortgagee-bank will have the opportunity to object to the lien strip, usually on the basis that the debtor’s appraisal is too low and that there is equity which at least partially secures the second mortgage so that it cannot be stripped under the law. However if no objection is filed or the bankruptcy judge finds that the value of the home is such that the second mortgage is entirely unsecured, the mortgage will be stripped from the property at the successful completion of all payments due under the chapter 13 plan.
Option #2: Chapter 13 Cramdown of ‘Short Term’ 2nd Mortgage:
If option #1 does not apply because there is some equity which at least partially secures the second mortgage, a chapter 13 debtor may still have an option to “cram down” the balance of the second mortgage. In this option, the balance of the second mortgage is effectively reduced to the amount of equity in the property which secures that mortgage. A chapter 13 cramdown can only be done if the second mortgage is “short term” under the Bankruptcy Code, i.e., the mortgage either has become due prior to filing bankruptcy or will become due during the 5-year chapter 13 plan. This option will not apply if the second mortgage does not become due until after the 5-year chapter 13 plan ends, i.e., the mortgage is not “short term”. Assuming the second mortgage is short term, section 1322(c)(2) of the Bankruptcy Code provides for the mortgage to be bifurcated into two parts: 1) a secured claim which must be paid off in full, through the chapter 13 plan in no more than five years and at a low interest rate; and 2) an unsecured claim which, like all other unsecured creditors, is typically repaid a fractional dividend of the total amount of the claim and the balance of the claim is then dischargeable at the end of the chapter 13 plan. Depending on the amount of equity which secures the second mortgage and the potential savings on lowering the contract interest rate to perhaps 4% or 5%, a chapter 13 cramdown can be greatly advantageous and offer a vehicle to pay off a second mortgage for less than owed. This option is also particularly appealing for homeowners whose short term mortgages have already ballooned or soon will balloon and the homeowner is unable to pay off the amount due or otherwise refinance under favorable terms.
For more information about the advantages of chapter 13 bankruptcy, keep reading Chapter 13: Not Always a Gloomy Diagnosis in Bankruptcy.