You Can Strip Your Second Mortgage-But Should You?

29 Oct You Can Strip Your Second Mortgage-But Should You?

6447393819_13224928d7_mOne of the types of relief available to help restructure your finances in Chapter 13 cases is the possibility of “stripping,” or eliminating a second mortgage when (and only when) the value of the house is less than the balance of the first mortgage.* My friend and colleague Russ DeMott gives an example from his practice:

The clients owed $270,000 on a first mortgage and $51,000 on a second mortgage on their residence. Under these circumstances, the law is clear: (1) the first mortgage cannot be modified since it’s a debt secured solely by a mortgage on the clients’ residence, and (2) the second, $51,000 mortgage, can be modified if the property is worth less than what’s owing on the first mortgage (in this case less than $271,000). Assuming that’s the case, the second mortgage is wholly unsecured. In foreclosure, the second mortgage holder would not receive anything. And, in turn, if that’s the case, the second mortgage can be stripped off in a Chapter 13 bankruptcy.

So lets say your situation matches that scenario; you have two (or more) mortgages on your home, but your property is worth less than the first mortgage. So when should you take advantage of the lien stripping available in Chapter 13, and when should you pass it up?

First of all, Chapter 13 is a bankruptcy. It is going to affect your credit, and it should be used only as a part of a plan for relief that makes sense given your overall situation. For example, if you have a second mortgage with a favorable fixed interest rate, and your income is such that you are going to be required to pay 100% to all creditors anyway, a lien strip in Chapter 13 may not confer enough of a benefit to overcome the negatives. On the other hand, if your income has dropped, and you can’t afford your house any other way, it may be worth doing. Similarly, if your second mortgage is a monster, with an interest rate well above market, it may make sense to do a Chapter 13 with a lien strip.

Another critical consideration is this: lien stripping may not work unless you are able to complete your Chapter 13 Plan, which is generally three to five years. If you are anticipating a change in income (like retirement) or expenses (like a child starting college) during that time, it may not be a good option. The same may be true if you are self employed, or if your income is less than reliable. This, too, is a function of how much you will save. If your second mortgage is relatively modest, and the payments affordable, it may not be worth the risk of being unable to complete the plan. If you attempt to strip your second mortgage but can’t complete your plan, your payments will be behind, with possible negative consequences.

Also critical to deciding whether a lien strip is appropriate is whether the payments on the second mortgage are current, or whether they are behind. If the only way you can afford to keep the home, it may be worth taking the risk to do a lien strip. But if the payments are current, and continuing to make those payments doesn’t cause a hardship, you may want to carefully consider the risks inherent in a Chapter 13 lien strip

In addition to questions about whether a lien strip makes sense financially, you also want to be sure that the plan process is done correctly, so that you can convey clear title when the time comes. There is even another option, a so-called “Chapter 20” bankruptcy, which can be useful in the right situation. Given all these considerations, the assistance of a good bankruptcy lawyer is extremely important. Look at it this way–if you are getting rid of your entire second mortgage, it’s worth paying a good lawyer to ensure that it is done right.

*It is important to note that lien stripping is available ONLY in Chapter 13, and ONLY when there is NO equity over the first mortgage. If your property has ANY equity over the first mortgage, even a nominal amount, lien stripping is not available.

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