Strip off that second mortgage

Posted by Kevin on October 30, 2010 under Bankruptcy Blog | Be the First to Comment

You bought your house for $300,000 in 1997.   By 2003, the value went up to $420,000.  You refinanced at $380,000 with an adjustable rate mortgage  The value of the house increased to $460,000 by 2005.  You wanted to consolidate your credit card debt so you draw down $60,000 on a home equity line (HELOC)  in 2006.  Things are going all right but then your mortgage adjusts upward and you owe another $600 per month.  The HELOC payment goes up too.  Then, someone gets sick or loses a job, you miss a couple of mortgage payments.  Before you know it, you are in financial trouble. You are thinking about bankruptcy.

If you do file bankruptcy, should it be under Chapter 7 or 13.  A Chapter 7 will take care of credit cards and medical bills but can’t do much about the mortgages because they are what is called secured debt.  A Chapter 13 can save your  house but do you have to make payments on both mortgages?  Maybe- Maybe not.  Under certain circumstances a Chapter 13 debtor can eliminate that second mortgage.

For all practical purposes, you must pay your first mortgage under its terms.  You pay going forward and you pay any arrears monthly under your Chapter 13 plan.  How do you figure out whether you can do something about the second mortgage?

Well, in this scenario, the house was worth $460,00o in 2005.  The first mortgage is $385,000 with  arrears and the second mortgagee is up to $65,000 with arrears. That comes up to $450,000.  The Debtor must pay both mortgages in full outside the plan going forward and the arrears to the Trustee on a monthly basis spread out over the term of the plan.  No help there.

But don’t stop there.  If your house was worth $460,000 in 2005, it is probably worth much less than that today.  Most real estate has gone down in value by more than 30% in New Jersey over the last few years.  If the debtor’s house went down in value by 30%, it would be worth $322,000.  That would mean that the first mortgage is partially underwater (mortgage exceeds value of property) and the second mortgage is completely underwater.  If the second mortgage is completely underwater, then in a Chapter 13, you can strip off the second mortgage.  That means that it is no longer a secured claim that has to be paid in full, but an unsecured claim which can be paid according to your Chapter 13 plan with other unsecured claims.  If you have a 10% plan, that means that you can pay off the second mortgage for $6,500.  This is a huge savings.

It is essential to get a comparative market analysis at the beginning of the bankruptcy process.  If it shows that the value of your house has gone down significantly, you may be able to strip off a second mortgage.  But remember, the second mortgage must be completely underwater.  In other words, if there is $1 dollar of equity in the second mortgage (the house is worth $385,001), the whole second mortgage stays a secured claim and must be paid in full.