Debtors can use Bankruptcy to Eliminate Junior Liens and Stay in their Homes

     

A little known rule about bankruptcy is being used to eliminate junior liens and keep people in their homes.

     

Bankruptcy

     

The Chapter 13 bankruptcy code is written to eliminate unsecured debt held by a debtor who will never be able to pay. Mortgages are secured as liens against real property, so bankruptcy generally will not eliminate mortgage debt unless the debtor has already lost the collateral to his creditors. At least, that is the intention of the bankruptcy code – if you keep your home, you keep the debt secured against your home.

     

Chapter 13 Lien Stripping

     

However, courts will make exceptions for loans “secured” against a property where that property does not reasonably cover the value of the total debt. In those cases, the loans that were secured against vanished equity can be deemed unsecured. For example, if a home is worth $500,000, and the debtor’s 1st mortgage is for $600,000, the 2nd or 3rd mortgage really is not secured against any value. The home does not fully secure the first loan, and so the junior loans were never reasonably secured at all. This example should seem extreme, but it is precisely what we are seeing in this market.

     

The bankruptcy code gives courts authority to strip a lien and render a junior mortgage unsecured if there is not enough equity to cover the junior mortgage. The bankruptcy court can order the removal of a HELOC, a purchase money loan or any other type of lien on the property if it is was not reasonably secured by the true value of the property.

     

How it works

     

After filing the Chapter 13 bankruptcy, the debtor petitions the court for a hearing to request an order removing all junior liens from the property. Provided that the debtor 1) gets a valid appraisal that places the property value below that of the first mortgage, and 2) the debtor agrees to a first mortgage payoff plan that is acceptable to the court, the court will remove the junior liens and set aside the junior debt pending repayment of the secured debt. During this time, the junior debt is frozen and the debtor is not required to make payments toward it.

     

If the payoff plan is accepted by the court and honored by the debtor, the debtor will pay off his 1st mortgage and the secondary mortgage debt goes the way of all other unsecured debt in the bankruptcy.

     

Where this practice is most popular

     

Of course, this practice is more common in places where the market changes severely. A recent San Jose Mercury News article suggested that this practice is very common in the Silicon Valley due to the propensity for highs and lows