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Turn a Second or Third Mortgage Into an Unsecured Debt

If you’re like many homeowners, your home is encumbered with a first mortgage, a second mortgage (often used for the down payment in an 80-20 financing arrangement), and even a third mortgage (maybe in the form of a home equity line of credit). Most likely, the holder of the first mortgage is pushing the foreclosure. But if you have fallen behind on your first mortgage, you are probably behind on your second and third mortgages as well. Would it help you keep your house if you no longer had to pay the second or third mortgage? You know the answer: Lightening your overall mortgage debt load could only help you meet your first mortgage obligation.

One of the great features of Chapter 13 bankruptcy is that you can get rid of (strip off) all mortgages that aren’t secured by your home’s value. Let’s say that you have a first mortgage of $300,000, a second mortgage of $75,000, and $50,000 out on a home equity line of credit. Presumably, the value of your home when you took on these debts was at least equal to the total value of the mortgages, or $425,000. But if the house is now worth less than $300,000, as a practical matter the house no longer secures the second and third mortgages. That is, if the house were sold, there would be nothing left for the second or third mortgage holders.

If your second and third mortgages were considered secured debts, your Chapter 13 plan would have to provide for you to keep current on them. However, when they are stripped off, they are reclassified as unsecured debts. This means you have to repay only a portion of them—just like your other unsecured debts. And as explained earlier, the amount of your disposable income, not the amount of the debt, determines how much of the unsecured debt you must repay.

EXAMPLE: Sean files for Chapter 13 bankruptcy and proposes a three-year plan to make up his missed mortgage payments. He also owes $60,000 in credit card debt and has disposable income of $300 a month. His house’s value is $250,000. He owes $275,000 on his first mortgage, $30,000 on the second, and $15,000 on a home equity loan.

 

Because his house’s value has fallen below what he owes on the first mortgage, there is no equity left to secure the second mortgage or home equity loan. So his Chapter 13 plan would classify these two formerly secured debts as unsecured. When they’re added to the $60,000 in credit card debt, he’s got a grand total of $105,000 unsecured debt. Because all he has is $300 per month in disposable income, his plan would repay a little more than 10% of his unsecured debt—including a little over 10% of his formerly secured second and third mortgage debt.

This also means that under your Chapter 13 plan you won’t have to make up payments missed on your second or third mortgages. And because you’re no longer making current payments on the second or third mortgage, the total amount you pay each month will be reduced by a considerable amount.