Escape Your Underwater Second Mortgage

 Posted on May 20, 2016 in Mortgage

If your second (or third) mortgage is not backed by any equity in your home, you can “strip” that mortgage off your home’s title.

Our last two blog posts were about using Chapter 13 “adjustment of debts” as a practical way to catch up on late mortgage payments and property taxes. You always have to get current on property taxes and virtually always have to with your primary mortgage obligation. Chapter 13 gives you the time and protection to do this.

But if you have a second or third mortgage, you might not have to catch up at all. You may be able to “strip” that mortgage from your home. If so, you also won’t have to make the monthly payments going forward. And you would likely not have to pay any more into your 3 to 5-year Chapter 13 plan than if you didn’t have that second or third mortgage. Then at the end of the plan whatever is still owed on that mortgage would be forever written off.

IF No Equity Backing Up the Second (or Third) Mortgage

A mortgage “strip” only works if ALL of your home’s value is taken up by a lien or liens legally superior to the junior mortgage at issue. Liens legally superior usually (but not always) mean liens backing up debts which were recorded on your home earlier.

The mortgage attempting to be “stripped” can have no home value securing it at all.

Here are two examples.

First a very straightforward one: a home worth $200,000 with only two liens, a first mortgage with a balance of $205,000 and a second mortgage with a balance of $15,000. All of the home’s $200,000 of value is taken up by the $205,000 first mortgage, leaving none of that home value to secure the $15,000 second mortgage. That second mortgage could thus be “stripped” from the home in a Chapter 13 case. ($200,000 minus $205,000 = no equity.)

Second, a less straightforward example: a home worth $200,000, with an overdue property tax debt and lien of $4,000, a past due homeowners’ association fee and lien of $3,000, a first mortgage of $195,000, and a second mortgage of $15,000, with the liens legally arranged in that priority order. Without the property tax and homeowners’ association liens, not all of the home’s $200,000 of value would have been taken up by the $195,000 mortgage. So the $15,000 second mortgage would have been partially secured by the home’s value, and thus unable to be “stripped.” ($200,000 minus $195,000 = $5,000.)

But with the $4,000 owed in property taxes and $3,000 in homeowners’ association dues, and both secured by superior liens, all of the home’s $200,000 is taken up by the combined liens ($4,000 + $3,000 + $195,000 = $202,000), leaving none of that home value to secure the $15,000 second mortgage. That second mortgage could thus be “stripped” from the home in a Chapter 13 case. ($200,000 minus $202,000 = no equity.)

Effect of a Mortgage “Strip”

In a Chapter 13 case—but NOT in a Chapter 7 “straight bankruptcy” one—“stripping” the second mortgage in effect legally acknowledges that the debt owed in that second mortgage is completely unsecured. So it is treated just like your other “general unsecured” debts—medical bills, credit cards, unsecured loans, etc.

The pool of all your “general unsecured” debts in a Chapter 13 case are usually paid only to the extent that you have money left over in your budget to pay them.

Sometimes all of the available money during the term of your court-approved payment plan is used for catching up on your first mortgage, property taxes, and other essential “priority” debts (such as recent income taxes and/or back child support), so that there is nothing available for the “general unsecured” debts, including your second mortgage balance. So you’d pay your second mortgage nothing.

But even in the more common situations in which you did have some money available for the “general unsecured” debts, you would usually not have to pay any more towards those debts because of the second mortgage. That’s because usually you are obligated to pay a set amount towards that entire pool of “general unsecured” debts—based on what you can afford to pay after paying the more important debts. Almost always that set amount that you can afford to pay over the life of your payment plan only pays a portion—and often only a small portion—of the debts in that pool. The existence of the second mortgage debt just shifts around the same amount of money paid into the pool of “general unsecured” debts among those debts.

For example, assume you have a $15,000 second mortgage debt and $25,000 in other “general unsecured” debts, so a total of $40,000 of all your “general unsecured” debts. Your Chapter 13 plan has you paying a total of $5,000 towards this pool of “general unsecured” debts, each of which gets paid pro rata.

If you didn’t have the second mortgage debt, that $5,000 would be divided among the $25,000 of debts, with each receiving 20% of its debt. After “stripping” the second mortgage and turning it also into a “general unsecured” debt, now the $5,000 being paid into that pool would be divided among the $40,000 of debts, now with each receiving 12.5% of its debt.

Again, the $5,000 paid to that pool didn’t change. Most of the time how much you pay to the “general unsecured” debts doesn’t change with an increase in the amount in the pool.

Conclusion

So for practical purposes, “stripping” your second mortgage means you can immediately stop making payments on it, you don’t have to catch up on any missed payments, and you don’t effectively pay any more on it going forward.

Then at the end of your successful Chapter 13 case whatever balance you owe at the end is legally “discharged”—written off forever, and the lien taken off your home’s title.

If you have a second or third mortgage with no equity supporting it, that may be reason enough to choose Chapter 13. Because again this “stripping” cannot be done in a Chapter 7 case.