The Confusion with Mortgage Liens and Bankruptcy

The Confusion With Mortgage Liens: In my years of practice, one common misconception I have witnessed is the belief that a bankruptcy discharge wipes out secured mortgage debt. Failing to understand how bankruptcy affects unsecured debt, such as credit cards and personal loans, versus secured debt, such as mortgages and car loans, is critical to your financial success.

Below, I outline the critical distinctions between Chapter 7 and Chapter 13 as they relate to your home.

By Alexander Hernandez, J.D., Professor, and Author of Consumer Bankruptcy Law (Routledge).

Key Takeaways: Mortgage Liens & The Bankruptcy Code

• The “Mortgage Lien Survival” Rule: A Chapter 7 discharge eliminates your legal obligation to pay unsecured debt, but it does not eliminate a mortgage lien if you are keeping the house.
• Chapter 13 Bankruptcy: Chapter 13 is the primary tool used for “curing” a default and catching up with your missed payments. This option does not exist in Chapter 7.
• Surrendering Assets: If you hear of a mortgage being “wiped out” in Chapter 7, it almost certainly means the debtor surrendered the property to the lender. You cannot “wipe out” the debt and keep the asset simultaneously.
• Mortgage Lien Stripping Confusion: Stripping a second mortgage means reducing it to unsecured debt, which is only possible via Chapter 13, depending on the value of your home.
• The Pro Se Mistake: Filing without counsel often leads to the “zombie mortgage” trap, where a debtor stops paying a second mortgage, thinking it’s been wiped out in bankruptcy, only to face foreclosure years later.

The Survival of Liens: Why Chapter 7 Won’t Wipe Out Your Mortgage

A common error made by self-represented (pro se) debtors is the assumption that a Chapter 7 discharge eliminates the obligation to pay a mortgage while allowing them to keep the home.

The Rule: If you intend to keep the asset, you must continue to pay the secured creditor, whether a mortgage or car loan.

The Confusion: When debtors hear that someone “wiped out” a mortgage in Chapter 7, they are usually hearing a half-truth. That debtor likely surrendered the property. By giving the house back to the lender, the remaining deficiency balance is indeed discharged, but the debtor loses the home in the process.

Debt Restructuring or Reorganization: The Chapter 13 “Wage Earner’s Plan”

While Chapter 7 is a liquidation, meant for a “fresh start,” and non-exempt assets can be liquidated by the bankruptcy trustee, Chapter 13 is a reorganization. For homeowners who have fallen behind on payments, Chapter 13 is often the viable path to saving the home unless an agreement can be reached directly with the mortgage lender.

The Power of the Cure in Chapter 13

Unlike Chapter 7, Chapter 13 allows a debtor to “cure” a mortgage default.

The Arrears: You can take your past-due payments (arrears) and spread them over a 36-to-60-month repayment plan.

Foreclosure Stay: Filing the petition triggers the Automatic Stay, halting foreclosure proceedings and providing the breathing room necessary to catch up with the missed payments.

Mortgage Reduction or Elimination: Lien Stripping of Junior Mortgages

One of the most powerful, yet misunderstood, tools in the bankruptcy arsenal is “lien stripping.” This is generally exclusive to Chapter 13 and is only applicable to junior liens, such as a second mortgage or HELOC.

How Lien Stripping Works:

If your home’s current fair market value is less than what you owe on your first mortgage, any subsequent mortgages are considered “wholly unsecured.”

The Process: Through a Chapter 13 plan, you can request the court “strip” the second mortgage.

The Result: The second mortgage is reclassified as general unsecured debt. It is treated the same as credit card debt, meaning that the lender often receives only a fraction of the balance. The lien is removed from the property title upon successful completion of the bankruptcy plan.

Professor’s Note:  Lien stripping is not an option in Chapter 7 bankruptcy. However, it is this confusion that I see pro se debtors file for Chapter 7 and stop paying their second mortgage.

Years later, especially when the home’s values has increased, the second mortgage lender begins the foreclosure process. Because lien stripping is not an option in Chapter 7, the second mortgage holder still retains their secured interest. By the time the homeowner realizes the mistake, they are often facing years of accrued interest and late fees, putting them at immediate risk of losing their home.

Qualifying for Chapter 7 Bankruptcy: The Means Test Barrier

Before choosing which chapter in bankruptcy to file, you must confirm which one you qualify for. The Means Test analyzes your average income for the six months prior to filing against the median income in your state.

Below Median: Generally qualifies you for the simpler Chapter 7, but this also depends on non-exempt assets that are subject to liquidation and your disposable income when comparing Schedule I (Income) to Schedule J (Expenses).

Above Median: You may be pushed into a Chapter 13, where you must use your disposable income to repay a portion of your debts.

Professor’s Note: Twice a year, the figures for the Means Test are updated. An increase in the state’s average income would help you qualify for Chapter 7 bankruptcy. For the latest figures, please read this prior article.

The Professor’s Conclusion

Bankruptcy can help you get back on your feet, but it follows strict rules. Whether you have a regular mortgage or a reverse mortgage, knowing the difference between wiping out a debt and removing a lien can determine whether you keep your home or lose it.

Colleges and universities can purchase my bankruptcy law textbook directly from Routledge Publishing. Paralegals and students who are buying single copies can do so via Amazon Books. To access my YouTube channel, click this link.

You can learn more about filing for bankruptcy and the bankruptcy petition via this link. Information on the bankruptcy court system, contact information for trustees, and your state’s exemptions can be found here. The federal bankruptcy exemptions are listed here. The latest version of the 341 Meeting of the Creditors can be found here.

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