Bankruptcy & Second Mortgage Liens in a Chapter 7

BANKRUPTCY AND SECOND-MORTGAGE LIENS IN A CHAPTER 7

If you file for Chapter 7 bankruptcy, what happens to second or third mortgages and liens on your home? The real estate crash, and the resulting depreciation in home values, may mean that as a practical matter, many people won't have to worry about those liens. Here's why.
The Real Estate Crash Has Resulted in Many Unsecured Second and Third Mortgages. Basically that means that the value of the house is less than what is owed on the First Mortgage.

Because of the real estate crash, many people have second and third mortgages on their homes that are no longer secured by the home's value. For instance if your home is now worth $150,000 and you owe $200,000 on your first mortgage and $50,000 on your second mortgage, your home's value secures the first mortgage up to $150,000, but after that, there is no equity left to secure the second mortgage.

What Happens to Those Mortgages if You File for Bankruptcy?

In Chapter 7 bankruptcy, your bankruptcy discharge will eliminate your personal liability on the second mortgage but will not eliminate the lien. In Chapter 13 bankruptcy, you can eliminate both your personal liability and the lien in a procedure called lien stripping. Please see my website for details regarding lien stripping. The basic lien stripping rule is: You can eliminate a lien that has no security in the home, but you can't eliminate the lien if part of it is secured by the home's value.

Here's an example. Say your home is worth $210,000, your first mortgage is $205,000, and your second mortgage is $25,000. You can't strip off the second lien because it is secured by at least $5,000 of your home's value. But, if your home is worth $150,000, and your 1st mortgage is $200,000 and your second mortgage is any amount over that, you can “strip”, remove the 2nd mortgage lien from your house. However, this can only be done in a Chapter 13, NOT in a Chapter 7.

WHAT IF A LIEN REMAINS ON YOUR HOME AFTER CHAPTER 7 BANKRUPTCY?

Although you can't lien strip in a Chapter 7 bankruptcy, the lien may have very little effect on your future financial affairs. The Chapter 7 bankruptcy will discharge your personal liability for the second mortgage (meaning you can't be sued for money owed on it). And, absent value in the house securing the second mortgage, the holder wouldn't benefit from a foreclosure (since all the value of the home would go to the first mortgage holder in a foreclosure sale).

This means there won't be negative consequence from the lien remaining on the home after your bankruptcy -- unless of course your home's value comes back to a point that would allow you to sell the home or support a foreclosure action by the second mortgage lender. This is clearly less likely when your home is way underwater (50% is common) than when you are just a tad underwater. But remember, it still is a lien on your home. Which means that if you ever want to refinance it or sell it, you will have to deal with the 2nd mortgage, etc by either paying it off or negotiating a buy-out with them.

The bottom line? Even though you might have a better result in Chapter 13 -- where you can lien strip -- from a practical standpoint, people with severely underwater second mortgages may do just as well in a Chapter 7 bankruptcy.

This is just a quick over view. For more information please feel free to contact the Law Office of Mark A. Reed, 858-277-0232.