Debtors in Chapter 13 bankruptcies often have more than one loan on a single home. Especially since the Great Recession of 2008, it’s common for the house to be worth less than what is owed, also known as known as being “underwater.”
Bankruptcy law allows a way for debtors to get rid of a junior mortgage, while keeping the house. This is done by filing a “lien stripping” motion in bankruptcy court, which can lead to the junior loan going away after completion of a repayment plan, potentially saving thousands of dollars.
Secured and Unsecured Claims
A successful lien stripping motion transforms a junior mortgage from a debt that survives bankruptcy, called a “secured debt,” into an “unsecured debt” that gets discharged at the end of the bankruptcy.
It is important understand how the two types of claims are paid in bankruptcy.
Unsecured creditors rarely get anything. They wait until secured debt, priority claims (unpaid taxes, family support obligations), and living expenses get paid. Then they get what’s left over, also known as “disposable income.”
Secured Mortgages Must Be Paid in Full
Upon applying for a home loan, borrowers agree to give the lender a “lien” or “security interest” in the property. The lien allows the lender to foreclose if payments stop. To keep the house, borrowers are responsible for the outstanding mortgage balance until it’s paid and must stay current both during and after the Chapter 13 case.
Unsecured Creditors Receive ‘Disposable Income’
Unlike secured debt, debtors aren’t required to pay nonpriority unsecured claims (credit card bills, medical bills) in bankruptcy.
Unsecured creditors rarely get anything. It’s not unusual for unsecured creditors to recover a mere fraction of the original balance. After completion of a repayment plan, any remaining balance gets wiped out.
Converting a Junior Lien From Secured Debt to Unsecured Debt Saves Money
Converting a secured junior mortgage to unsecured debt makes financial sense. If successful, a junior mortgage will disappear with other unsecured debts.
Requirements for Lien Stripping
Successful lien stripping in a Chapter 13 bankruptcy involves two essential components: Prevailing on a lien stripping motion, and finishing a repayment plan.
A Junior Mortgage Must Be Underwater
To strip a lien, a motion is filed in bankruptcy court, asking the judge to reach two conclusions regarding the value of a house:
- The value of the house is less than what is owed (it is “upside-down” or “underwater”), and
- If the home is sold, there would be no money available to pay the junior mortgage (by virtue of the market forces, the secured junior loan has become “wholly unsecured”).
If the motion is successful, the judge will declare the junior loan “unsecured” and instruct the bankruptcy trustee — the person in charge of paying 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 during bankruptcy.
You Must Finish Your Repayment Plan
The second requirement for successful lien stripping is the completion of a repayment plan. If payments are missed while the plan is in force, the court will dismiss the case and the lien will stay in force, attached to the property, until the loan is repayed. A debtor will receive credit for the amount paid on their account during the bankruptcy, but nothing more.
Liens Cannot be Stripped in a Chapter 7 Bankruptcy
If a debtor files for Chapter 7 bankruptcy and wants to keep their house, they 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 prohibiting 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, the liens from junior mortgages can still be stripped. After discharge, the lender for the stripped lien will be required to remove its lien from your house.
Avoiding a junior lien requires expert testimony at an evidentiary hearing about the value of the house. Because of the complicated nature of lien stripping, it’s always a good idea to consult with a bankruptcy attorney like myself.
For a more detailed explanation of your lien stripping bankruptcy options, let’s schedule a consultation today.
Moshier Law Office, PLLC
St. Paul, Minnesota