Undersecured loans and chapter 13

Americans Owe More Than Their Homes are Worth

The aftermath of the housing crisis has left Americans owing more than their homes are worth, often much more.

With millions of American homes underwater and banks unwilling to modify mortgages, Congress is calling once again for legislation that would allow first mortgages secured by a borrower’s primary residence to be modified in a chapter 13 plan.

First Mortgages Cannot be Modified in Bankruptcy, But…

Despite rumblings from Washington, the current state of the law does not allow first mortgages on a borrower’s primary residence to be modified in chapter 13 bankruptcy. However, second and third mortgages are fair game. Let’s discuss.

Currently, debtors filing bankruptcy under chapter 13 may “bifurcate” secured claims of creditors. In many cases, lender’s security interests are only protected to the extent they are consistent with the value of the collateral securing the loan. In situations where a borrower is underwater on their mortgage, the amount of the debt that exceeds their property value  is treated under the Bankruptcy Code as unsecured, often paid at much less than 100% under the terms of a chapter 13 plan.

In Nobleman v. American Savings Bank the Supreme Court refused to apply this standard to a debtor’s principal residence, hence the current push for bankruptcy reform.

However, the Nobleman decision does not prevent second and third mortgages from being modified when those mortgages are completely “undersecured”, meaning the first mortgage amount totally exceeds the home’s value. For example, if your home is worth $350,000 and you owe $360,000 on your first mortgage and owe an additional $50,000 on a second mortgage, the second mortgage amount exceeds the value of your home (when the first position mortgage is factored in). In situations like this it is possible to “strip” the second mortgage from the home completely and pay out the debt, often at pennies on the dollar, over the life of a chapter 13 plan. Stripping of a second mortgage in this way operates as a judicially imposed mortgage modification.

The treatment of secured debt in chapter 13 is especially significant for borrowers in states like Florida and California who have seen home prices drop dramatically. If you are already underwater on a first mortgage, chapter 13 bankruptcy may allow you to modify the terms of your second and third mortgage substantially. If you have questions, contact a bankruptcy attorney.