Chapter 13 Bankruptcy Time Bomb: Mortgage Modification

by Eugene Melchionne, Esq.

February 14, 2012

Second Mortgage Time Bomb

One of the major benefits of Chapter 13 Bankruptcy is the ability to avoid second mortgages that are not secured by any value in your home.  By following standards outlined in the Bankruptcy Code, you can reclassify that loan on your home into the same category as credit cards or other ordinary bills and discharge them at the end of your Chapter 13 payment plan.  This is called lien stripping. You cannot do this to a mortgage in a Chapter 7 case.

However, if there is even a penny of value in the home that would go to a second mortgage when the property was sold, the loan cannot be valued as unsecured.  That means it must be paid during the Chapter 13 case and it also survives the Chapter 13 as a lien on the property until it s paid off.

So where’s the Time Bomb?  Let’s assume that you’ve been dealing with your lender trying to work out a modification of your first mortgage.  Well, what if your lender were to give you a modification that reduces your principal balance?  That modification now results in a little equity in your home.  Sounds like good news, right?  Nope.  With the reduction in the principal balance gives your second mortgage a toe-hold onto your home. Once that happens, the Bankruptcy Code will not allow you to avoid that second mortgage and gain the benefit of a Chapter 13 case.

In a New York Times article, reporter Gretchen Morgenson criticized the terms of the “Great Mortgage Deal” with five major banks,  Once of the points she brings out is that this “settlement” enhances the value of the second mortgage market.  By creating equity in homes, the value is now exposed to claims by second mortgage holders in a Chapter 13 thus weighing down homeowners with yet another obligation that survives a bankruptcy.  Once your first mortgage is reduced below the value of your home, the second mortgage will sink its claws into that home.  KABOOM!  Mortgage time bomb.

If there is any doubt that you should file a Chapter 13 Bankruptcy before you work our a debt reduction deal with your first mortgage, this should do it.  File first, work out the modification later, before that second mortgage gets you.

“ConnecticutGene Melchionne is a bankruptcy lawyer covering the entire State of Connecticut. He can often be found on Google+ and Twitter, where he shares information about consumer protection issues and personal finance.

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Last modified: November 17, 2013