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Is Your House Underwater? If You File a Chapter 13 You May Be Able to Strip Your Second Mortgage!

Posted on April 4th, 2011

With the recent drastic drop in home values, “lien stripping” can be one of the most useful tools available to debtors in a Chapter 13, who are “underwater.”  At the end of 2010, it was estimated that 10.8 million or 22.5% of all residential mortgages in America were in negative equity or “underwater.”

In Virginia, a Chapter 13 bankruptcy allows a homeowner who has two mortgages to strip the second mortgage if the principal balance of the first mortgage is greater than the fair market value of the home.  For example, if your home’s fair market value is $200,000 and you owe $205,000 on your first mortgage and $50,000 on your second mortgage, in a Chapter 13 you could strip the second mortgage.

This means the second mortgage becomes classified as an unsecured creditor and will receive the same payout as all your other unsecured creditors, usually much less than 100%.  At the end of the Chapter 13 plan, the bankruptcy court will enter an order discharging the debtor from their debts, including the second mortgage.   Thus upon successful completion of the plan, the debtor will no longer owe the second mortgage company any money, nor will the second mortgage company have any rights with regard to the property.

The theory behind this law is that because there is no equity in the property after the first mortgage is paid, the second mortgage company has no real security in the property to which a mortgage would attach; therefore, they are unsecured and should be treated as such in a Chapter 13 bankruptcy.

Currently not all circuits approve of lien stripping.  Recently the 4th Circuit Court of Appeals affirmed a Bankruptcy Court’s ruling from the Eastern District of Virginia, approving lien stripping, so this practice is alive and well in Virginia.  Consult with a local bankruptcy attorney to see if this practice is allowable in your circuit.