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Can Bankruptcy Shed Your Second Mortgage?

November 7, 2012

There’s an old proverb that says, “It’s an ill wind that blows no good.” If you’re facing financial distress, keeping this adage in your mind may encourage you as you and your family deal with troubled times. In fact, in many situations, bankruptcy is the good that bad financial winds blow.


The ability to discard a second mortgage, a process known as “lien stripping,” is one example of how bankruptcy can give debtors added financial options. How does this work?


At its creation, a home equity loan is a secured debt. In the event of a home foreclosure, the primary mortgage would be paid, then the second mortgage. But what an unforeseen recession causes home prices to plummet? A homeowner could look up and discover that he’s “underwater,” his debt on the home exceeds its fair market value. In this case, for the creditor holding the second mortgage, there is no underlying asset to protect his risk. As a practical matter, the asset (i.e. the home equity) that shielded his interests has evaporated.


Should the second lienholder still receive secured creditor status? Most bankruptcy courts agree that a Chapter 13 debtor may strip away his lien and return him to a position based on adjusted fair market home prices. After the lien is stripped away, all the remains are the debtor’s potential for future equity and the creditors’ secured claims up to the value of the home. Any debt is excess of reclassified as unsecured and discharged.


Lien stripping has some positive short-run effects, such as lowering monthly payments on debt, but the big win for the homeowner is that he doesn’t have to climb out of two financial holes, only one. And as home values appreciate in the future, he owns the potential upside, not a home equity creditor.


Want to find out more about how bankruptcy may be able to help you and your family reach solid financial ground? The attorneys and professionals at Fears Nachawati know how to care for your legal interests. Contact us today for your free consultation.


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