…or how to get rid of the underwater second mortgage, from a recent Ezine article by David Reinholtz, founder of LoanOfficerSchool.com, a speaker and an approved education provider for NMLS:
One day Suzie homeowner reviews her personal finances and comes to a stomach-churning realization: the house that she has lived in and made payments on and invested with her dreams is worth less than her total mortgage debt. She is deeply “underwater.” Her financial situation is serious enough so that she contemplates Chapter 13 bankruptcy. But in reviewing her options, her attorney tells her about something called “second lien strip.” Resisting the urge to slap him across the face at this seemingly risqué suggestion, she listens. He outlines a scenario.
Ten years ago Suzie bought her home for $295,000. Today it is worth $215,000. She owes $250,000 on her first mortgage. To make matters worse, a few years ago during the real estate boom her home was appraised for $350,000. Feeling confident, Suzie took out a second mortgage for $25,000 from ABC Finance. At the time it seemed like a safe enough bet. She spent the money on some unsecured debts, home improvements, and a new powerboat that she keeps on the lake. Today she owes $20,000 on the second mortgage.
Her house is worth $215,000. She owes $250,000 on her first mortgage and $20,000 on the second. Clearly there will not be enough money from the sale of the home to pay off the first mortgage, let alone ABC Finance.
Suzie files Chapter 13 bankruptcy. Her attorney explains that under Chapter 13, she can keep her home but will be required to use her income to repay some or all of her debts. A court-sanctioned Chapter 13 bankruptcy plan pays off most secured loans first and delays payment of unsecured debts. The representative from ABC Finance insists that because her second mortgage is secured debt, ABC needs to be at the front of the line for repayment.
The courts have disagreed. To understand why, it’s helpful to refer to the U.S. Bankruptcy Code. Here is the relevant excerpt from 11 USC 506 – Sec. 506 – Determination of secured status:
“(a) An allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under section 553 of this title, is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor’s interest or the amount so subject to setoff is less than the amount of such allowed claim.”
Courts have ruled that because a second lien like Suzie’s ABC Finance mortgage is debt that is not supported by equity, the debt is by definition unsecured. If Suzie’s second lien is stripped, the court will classify it as an unsecured debt in the payoff plan. Suzie will be able to pay a fraction over five years, just like her credit card debt. The actual percentage that she must pay will depend on factors including her income and the value of unencumbered assets.
For this strategy to work, you must consult a qualified attorney. Your home must be underwater on your first mortgage (or if you have multiple liens, underwater on at least the last one). If this applies to you, you can take comfort in the fact that you have lots of company; recent studies suggest that nearly one-quarter of Americans are underwater on their home mortgages.
I come across this issue all the time. Lien stripping has been permitted for 30 year, but implemented only when assets are over-encumbered, such as our current economic situation.
The downfall of filing BK, however, is that the BK record has a negative impact on your credit report for approximately 10 years.
The credit impact is far less that the “world at large” would have you think. Scores can be rebuilt in 2 or 3 years. Sure the line-item itself of a bankruptcy or foreclosure remains for 7 – 10 years, but it’s the scores that matter.