One of Chapter 13’s superpowers is its ability to strip off otherwise valid, voluntary liens on a home.
Ordinarily, liens survive a bankruptcy discharge as a charge on the collateral; it’s the borrower’s personal liability that is wiped out.
But Chapter 13 allows the elimination of liens when the lien isn’t really secured by any value in the collateral.
Rules of lien stripping
This is law, so you knew there’d be rules:
- A voluntary lien, like a deed of trust securing a second loan, line of credit, or HELOC, can be voided only in Chapter 13 or Chapter 11.
- It can be stripped only if there is no equity in the property after deducting the payoff balances of the liens senior to the lien from the fair market value of the property.
- The lien is permanently voided only upon the successful completion of the reorganization plan.
Thanks to lobbying by the mortgage lenders more than twenty years ago, bankruptcy courts are prohibited from compelling any changes to mortgages liens secured only by the debtor’s home.
So, the work-around, if you like, is a finding by the bankruptcy court that the junior lien isn’t really “secured” by any value in the home. If it’s not secured, the prohibitions don’t apply.
If there is a dollar’s worth of equity in the property, the lien must remain. A dollar out of the money, and the whole lien is gone.
Limits on bankruptcy relief
As a result of the limitations imposed by Congress, the help for homeowners that bankruptcy reorganization provides is limited to voiding totally unsecured liens and to eliminating other debts of the homeowners.
Limitations don’t apply to real property not acquired to be the borrower’s principal residence
Legislation passed by the House of Representatives in 2009 would have overturned the prohibition on modifying home loans and allowed judges to reduce mortgage balances to the present value of the home and alter other terms of the loan if the borrower was willing to file bankruptcy and successfully made the plan payments. The Senate defeated the bill, so bankruptcy judges remain powerless to weigh in on the tug of war between the mortgage bankers and the homeowners.