Getting Rid of a Second Mortgage in a Chapter 13 Bankruptcy

Debtors who file under chapter 13 may have the option of getting rid of a second or third mortgage, or home equity line of credit. This option is generally available to debtors whose properties have dropped significantly in value. If by virtue of the value drop the second mortgage becomes unsecured, meaning there is not enough equity to secure the second mortgage at all, it can be "stripped" from the property.

When a borrower is given a large loan for the purchase of a property, or for a large line of credit, the loan is often secured by property whose value is equal to or greater than the loan amount, usually by way of deed of trust (some secured loans are cross-collateralized, meaning multiple pieces of property become collateral for one loan). The security is assurance that the lender will have recourse in the event the borrower defaults, usually by allowing the lender to sell the property at a foreclosure sale.  When it comes to purchase money mortgages, loans used to purchase the property that secures the loan, the lender may break the loan into two mortgages, with two deeds of trust.

When a homeowner borrows against her property, she is using the equity or appreciation in value as collateral for the loan.  A deed of trust is recorded against the property to establish the security.  Deeds of trust are based on priority; subsequent recordation of new deeds of trust against a property are "junior" to any preexisting deeds of trusts (mortgages).  For example, a homeowner owns a house that is worth $400,000.00.  The balance owed on the first mortgage is $350,000.00.  The borrower obtains a $50,000.00 home equity line of credit from a bank to use in making improvements to the house (the way the funds are used is irrelevant to this example), which is secured by a second deed of trust.  Both loans are fully secured: the first mortgage is fully secured by $350,000.00 of equity in the property, and the remaining $50,000.00 in equity secures the equity line in full.

Let's say the value of that same property falls to $325,000.00. Now the first mortgage is under-secured by $25,000.00, leaving no equity to secure the second mortgage.  The debtor may seek to value the second mortgage at zero and remove it from the property.

Although the mortgage may be stripped from the property, the debtor's personal liability as to the now-unsecured $50,000.00 is much akin to how credit card debt is treated in a chapter 13.  She may be required to pay none, some, or all of that debt through her chapter 13 plan, depending on what the Court determines her "disposable income", money left over after deduction of reasonable expenses, to be.