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Eliminating Payments on a Second or Third Mortgage

As property values fall, second and third mortgages are frequently left unsecured. In other words, the property is no longer worth enough to guarantee their payment.

EXAMPLE: Henry bought his house for $450,000 with a first mortgage of $400,000. The house quickly grew in value to $500,000, and Henry got a $40,000 loan, secured by the new equity. A year later, his house’s value has sunk to $375,000. Now Henry’s first mortgage is only partially secured, because if the house were sold now, the loan couldn’t be repaid from the proceeds. The second mortgage is completely unsecured.

If you find yourself in this situation, and you are current (or can get current) on your first mortgage, you can probably keep your house and at the same time eliminate the amount you owe on the second or third mortgage in Chapter 7 bankruptcy. The mortgage holders would continue to have liens (legal claims) on your property after your bankruptcy was completed, but they could not, as a practical matter, enforce the liens unless the house developed sufficient value to make foreclosure worthwhile.

A little background may help you better understand this point. Whenever you take out a mortgage or deed of trust, two legal claims are created:

• a claim for the debt (created by a promissory note) that can be enforced by a lawsuit, and
• a lien on the property itself, which uses the property as security for the debt.

A bankruptcy discharge will eliminate the debt created by the promissory note, but not the lien that the mortgage or deed of trust creates on the house.

In Henry’s case, the second mortgage lender is in a difficult position if Henry stops making payments on the second mortgage. The lender technically has the right to foreclose. But that wouldn’t make financial sense, because a foreclosure sale wouldn’t produce enough money to pay off even the first mortgage lien—and so wouldn’t generate anything at all for the second mortgage lender. (The first mortgage, used to buy the house, always has priority over later ones.) As a practical matter, all the second mortgage lender can do is to sue Henry for the entire mortgage ($50,000), which Henry continues to owe. But if Henry files for Chapter 7 bankruptcy, he can get rid of the debt permanently. The lender would be left with a lien on Henry’s house that would be unenforceable unless the house’s value surged back up.

This is a very hard concept to understand, and if your head is swimming, you’re not alone. Perhaps another example will clear it up. If you have a second or third mortgage on your house, it’s worthwhile staying with this.

EXAMPLE: Three years ago, Paula borrowed $250,000 from a local bank to buy her first house, which cost $260,000. She borrowed $10,000 from her parents for her down payment. The bank loan is secured by a first mortgage on the house, while the loan from Paula’s parents is a personal loan; it wasn’t accompanied by a security agreement pledging the house as collateral.

 

Over the next two years, the value of Paula’s house increased to $350,000. She took out a $35,000 home equity loan to remodel her kitchen and landscape her backyard. As with the first mortgage, the home equity loan was secured by the house. At this point, Paula still had $55,000 equity in her home ($350,000 minus the $260,000 mortgage and the $35,000 the home equity loan). If Paula had stopped paying on the home equity loan, the lender could have foreclosed; the sale probably would have produced enough money to pay off the first mortgage and the $35,000 home equity loan. Any money left over would have been returned to Paula.

 

But over the last few months, the value of Paula’s house has sunk from $350,000 to $225,000. Paula has lost her job and can’t keep making payments on the home equity loan. The home equity loan lender sends her messages threatening foreclosure, but a HUD-approved housing counselor tells Paula that a foreclosure action is highly unlikely because the lender would get nothing from the sale—every penny from the foreclosure sale would go toward paying off the first mortgage.

 

After a while, the home equity lender sues Paula to recover the amount of the loan. Paula files for Chapter 7 bankruptcy and gets a discharge of all her debts, including the unsecured loan from her parents and the debts owed on her first mortgage and the home equity loan. The lawsuit filed by the home equity lender against Paula is dismissed. However, the bankruptcy doesn’t affect the liens that the mortgage lender and home equity loan lender have on Paula’s home. Just as before the bankruptcy, as long as the value of the house isn’t enough to pay any portion of the home equity loan if the house were sold at a foreclosure sale, foreclosure by that lender is out of the question.

 

Years later, property values shoot up again, and Paula’s house is worth about $300,000. The home equity lender moves to foreclose on the property because there is now enough equity to pay off both the first mortgage ($250,000) and the $35,000 home equity loan.