Most homeowners facing foreclosure would rather avoid both losing the home and having to file bankruptcy. They are concerned about the social stigma of filing, the damage to their credit record for the next seven years, and the difficulty of borrowing money for a home or auto loan in the future. However, there are a number of benefits, under the right circumstances, to filing for protection under the federal bankruptcy laws to reduce mortgage debt.
One of the greatest of these benefits is that, with a Chapter 13 (reorganization) bankruptcy, the courts are able to take secured junior mortgage loans and have them unsecured. Any second or third mortgage or Home Equity Line of Credit (HELOC) can be reclassified as an unsecured debt for the purposes of bankruptcy. Of course, this can not be done in every instance, and there are requirements that must be met by the loan and the value of the property.
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To take a mortgage off of a property, the loan must no longer be secured by the home's value. For example, take the following case of a property that has declined in value after several loans were taken out on it:
Home Value: $250,000
First Mortgage: $265,000
Second Mortgage: $40,000
HELOC: $15,000
The second mortgage and HELOC in the above example are no longer secured by the value of the property; in fact, even the first mortgage is only partially secured. This is not a rare example, either, as many homeowners have taken out more than one loan on a house, lenders relied on inflated appraisals, and now property values have crashed back down to reality.
If the owners of the property declared bankruptcy, these two junior liens could be reclassified as unsecured. Even if the house could be sold for its fair market value at the present time ($250,000), the second mortgage company and HELOC provider would receive nothing from the proceeds - therefore, they are, for all practical purposes, unsecured by the property right now.
But what does this really mean for homeowners? Who cares if a debt is classified as secured or unsecured? After all, the bankruptcy filers have to pay back the money they borrowed and pledged their home as collateral, right?
Wrong. When bankruptcy judges take a secured lien on a home and reclassify it as unsecured debt, the balance can be reduced on it. Homeowners would not have to pay back nearly as much as they owed on the debt and the mortgage would be treated just like any other unsecured loan like a credit card or personal loan. This can represent a significant savings to the homeowners and a large loss to lenders that made ill-advised loans on properties whose values have now fallen.
Even better, the amount that homeowners are required to pay back to a lender is determined by their income - not the original amount of the debt. In a Chapter 13 bankruptcy case, petitioners are put on either a three or five year payment plan, and their disposable income is used to calculate how much money the lenders will paid back on their loans. For families whose income has dramatically fallen due to job loss, this may be a way of bringing their debt load back in line with their ability to pay.
Chapter 13 bankruptcy, just like any other solution to foreclosure, is not right for everyone. But for homeowners who qualify, can afford the payment plan, and have consulted with a good personal bankruptcy lawyer, the ability to reduce their debt burden on second mortgages or equity lines of credit represents a large benefit for filing.
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