The tale of two mortgages begins something like this: the real estate market is booming and property values are soaring. A clever homeowner decides to take out a second mortgage or home equity line of credit (HELOC) on his/her home to pay some credit cards, purchase a boat, or buy an investment property. It’s easy enough to do and looks like a surefire idea. This is a happy tale. Flash forward about three years, and things begin to look a little grim. House values have fallen, and now that second loan is sopping up any chance at equity the home had. The homeowner is now burdened with two house payments and desperately wants to get out and recoup whatever value in his/her home. Is this a tale with no happy ending? Not quite…
We see this tale many times as bankruptcy attorneys, and there is some relief we can offer. A burdened homeowner does have the possibility of getting out from that second mortgage or HELOC through a Chapter 13 bankruptcy. If you are not familiar with bankruptcy, a Chapter 13 is kind of like a super debt consolidation plan. Debts are consolidated and broken into different priorities of debts. The lowest priority, general unsecured debts (i.e. credit cards) are usually paid a small portion of what is owed, and the remainder is discharged. It’s a super debt consolidation because it is done through the bankruptcy court and under all the protections of the bankruptcy laws. The repayment period lasts anywhere from three to five years, depending on the debtor’s income.
A Chapter 13 can be the hero of the tale of two mortgages because of something called the “cram down” or “strip off” provision. Interpreted from sections 506(a) and 1322(b)(2) of the bankruptcy code, the “strip off” provision allows a completely unsecured junior lien on a residence to be treated as a general unsecured debt in the Chapter 13. Which means, in a Chapter 13 you can, potentially, get rid of the burdening second or third mortgage(s) and have the lien released upon completion of the Chapter 13. However, the junior lien(s) must be completely unsecured, meaning that house must be valued lower than what is owed on the senior lien so that there is not even $1.00 of equity in the junior liens. If you can prove this, you can get rid of those extra mortgages and free up equity in your home, which is a pretty good ending to this tale.
Is this happy ending only available in a Chapter 13? For the time being it looks like the answer is yes. Several courts have addressed whether a debtor can strip off a second mortgage in a Chapter 7. In April of this year, the United States District Court for the Eastern District of Wisconsin determined that the provision is not available in a Chapter 7 bankruptcy, but is available in a Chapter 13 where a debtor would not be eligible for a Chapter 13 discharge, as long as the bankruptcy was filed in good faith. But, a bankruptcy judge in the Eastern District of New York has said otherwise and determined the lien could be stripped in Chapter 7. Bottom line, we do not really know if a “strip off” would be allowed in a Chapter 7. In which case, I advise only try it through a Chapter 13.