People take out second mortgages or home equity loans for all sorts of reasons. During the boom, a second mortgage was a way to leverage the equity created by rising home prices. The money would be used for home improvements, a vacation, a business start-up or any added living expense. When the recession hit, second mortgages, where available, were used to pay college tuition, for example, or to make ends meet during the job hunt.
When that job did not come along, or when that job paid a lot less than the last one had, the second mortgage became just one more obligation, another debt in a pile of unpaid debts. Many of us hoped that the mortgage crisis would be short-lived, but it was not. As a result, a debt load that was barely manageable became insurmountable. Personal bankruptcy was a reasonable way to get a fresh start.
Bankruptcy is not reserved for people who have no income. Debts can pile up during a period of unemployment and continue to go unpaid with a lower-paying job. For many with steady incomes that simply cannot meet their financial obligations, a Chapter 13 repayment plan would make sense.
As we were saying in our last post, a repayment plan will give the highest priority to secured loans. That's where the second mortgage should go -- the house is the collateral for both the mortgage loans. If the homeowner were to default on those loans, the lenders would both have claims to the proceeds of a sale, for example.
The recession, however, put many homeowners underwater on their primary mortgages. The house -- the collateral -- was worth less than the debtor owed. If the house were sold, then, how could a sale of the property satisfy both the primary and second mortgage?
The Bankruptcy Code allows those second mortgages to be changed from secured to unsecured debts. They are stripped of their secured status and moved to the same category as credit card debt and unpaid medical bills. This is lien stripping, and the law only applies to Chapter 13 bankruptcies.
One bankruptcy professional explained the law this way: The first mortgage places a lien against the home. The second mortgage really only places a lien against the homeowner's equity, not the home itself. When that equity disappears, the lien is no longer secured.
Source: Nolo.com, "Getting Rid of Second Mortgages in Chapter 13 Bankruptcy," Baran Bulkat, accessed June 8, 2015