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What is 'lien stripping'?

The U.S. Supreme Court released its decision in Bank of America v. Caulkett on June 1, and just about everyone who has anything to do with bankruptcy has been talking about it ever since. The Court was asked to decide whether a Chapter 7 liquidation debtor can void a second mortgage when the collateral property is worth less than what the debtor owes on the first mortgage. The answer was unanimous: No.

Perhaps the most important thing to note is that the ruling applies only to Chapter 7 bankruptcies. The rules for Chapter 13 are unchanged. For anyone interested in the facts and the Court's reasoning, Forbes.com and SCOTUSBlog.com have terrific explanations of the case and its implications. Here, though, we would like to take a few steps back and look at voiding second mortgages in bankruptcy, a process known as lien stripping.

We tell debtors all the time that filing for bankruptcy may protect their homes from foreclosure. As you can imagine, this was a particular concern during the financial crisis and recession. It was easy to get confused: In a Chapter 7 bankruptcy, the equity in your home is exempt from creditors -- you get to keep up to $30,000 of equity. But what happens if you owe more on your mortgage than the house is worth? Can you keep your home or hold onto any part of your investment when you are "underwater"?

In Chapter 13, the confusion melts away -- almost. A Chapter 13 repayment plan does not require a debtor or the bankruptcy trustee to liquidate any assets. The debtor pays the debts off based on his ability to pay.

Secured debts, like your mortgage or your car loan, have priority over unsecured debts. The security is the property: If you don't pay your mortgage, the bank will foreclose on your home. If you don't pay your car loan, the lender can repossess it. Their priority status means they will get paid first. When those debts are satisfied, the unsecured creditors will be paid. In Chapter 13, then, you can keep your home and the rest of your property as long as you hold to your repayment plan.

What does all of this have to do with lien stripping? We'll explain in our next post.

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