Lien Stripping

Question: I own a home that has declined in value and is now worth $515,000. I have a first mortgage in the amount of $480,000, a second mortgage in the amount of $50,000, and a third mortgage in the amount of $35,000. I want to keep my home. Is it possible, through bankruptcy, to eliminate my second and third mortgages since the house is worth less than I owe?

Answer:
The third mortgage can likely be eliminated, but not the second mortgage.

In bankruptcy, money that is owed to a creditor may be either an unsecured claim or a secured claim. Credit card debt is mostly unsecured claims. Debt for the purchase of a home or a vehicle is usually secured by a lien on the real estate or personal property, and thus is secured claims. Section 506(d) of the Bankruptcy Code states that “To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void…” So a lien on a credit card debt would be void; a lien on your home would not normally be void.

However, a creditor’s interest is secured only to the value of that interest in the property. It is unsecured to the remainder of the creditor’s interest. In the example, the first mortgage in the amount of $480,000 is completely secured because the value of the real estate exceeds the first mortgage. However, after the first mortgage is paid, there will remain only $35,000 for the second mortgage. This $35,000 will be the secured claim of the second mortgagee who will also have a $15,000 unsecured claim. The entire $35,000 third mortgage will be unsecured.

In 1992, the U. S. Supreme Court ruled that a Chapter 7 debtor cannot use Section 506(d) to avoid a lien on real property.[Footnote 1] Section 1322(b) of the Bankruptcy Code further protects mortgage lenders by disallowing a Chapter 13 debtor from modifying the rights of holders of claims secured by interests in real property that is the debtor’s principal residence. However, courts have ruled that Section 1322(b) does not prevent a Chapter 13 plan from modifying “wholly unsecured debts.”[Footnote 2] In the example, the second mortgage is partially secured so it cannot be modified. The third mortgage is “wholly unsecured” and can be listed on the Chapter 13 plan as an unsecured debt.

After a Chapter 13 plan has been confirmed, the debtor can convert the case to a Chapter 7 filing. Under Chapter 7, the unsecured debt can be discharged. The third mortgage would then be eliminated, but the first and second mortgages would continue as before. Eliminating the third mortgage seems fair, in this instance, since the mortgagee would receive nothing in the event of foreclosure. The restrictions on loan modification for loans secured by real property that is the debtor’s principal residence serves to increase the availability of home loans by offering some assurance to the lender that they will be repaid. It was not the intent of Congress to offer the same assurance to other lenders who supply funds for debt consolidation or home improvement.

Footnotes
1. Dewsnup v. Timm, 502 U.S. 410 (1992)
2. In re Phillips, 224 B.R. 871(Bankr. W.D. Mich. 1998)