The Confusion with Mortgages and Bankruptcy

Filing for bankruptcy, whether Chapter 7 or Chapter 13 can be confusing. I have witnessed debtors confused about how bankruptcy affects a mortgage and, sometimes, put themselves in a worse position financially when the mortgage lender starts the foreclosure process. In this blog I will discuss the common mistakes I see made by debtors.

Key Points:

• If you keep your home, Chapter 7 bankruptcy will not eliminate the mortgage.
• Chapter 7 bankruptcy is known as a liquidation, while Chapter 13 is known as a wage earner’s plan or reorganization.
• Not all debts are dischargeable in bankruptcy, including secured debts such as a mortgage if you keep the house.
• Chapter 13 bankruptcy may reduce a second mortgage.

Unfortunately, I’ve seen self-represented debtors filing for Chapter 7 bankruptcy, believing it will wipe out a mortgage. To be clear, Chapter 7 bankruptcy has never been an option for eliminating a mortgage. There are two reasons why debtors believe Chapter 7 bankruptcy wipes out their mortgages.

The Property was Surrendered

Certain debts cannot be discharged in bankruptcy. One category of debt that cannot be discharged in bankruptcy is secured debt if you are keeping the asset. For example, if you still have a loan on your car or a mortgage on your home, filing for bankruptcy will not eliminate that debt.

Unfortunately, self-represented debtors seem to hear that someone eliminated their car loan or mortgage payments, not realizing that the asset was surrendered. At that point, the debt is wiped out because they no longer own the car or the mortgage.

Confusing Chapter 7 with Chapter 13 Bankruptcy

Chapter 7 is the most common type of bankruptcy case filed. A typical Chapter 7 bankruptcy case has no assets or minimal assets protected by exemptions. Remember that exemptions vary per state, meaning certain assets are protected when filing for bankruptcy. I recently posted a video summarizing Chapter 7 bankruptcy that you can see by clicking the link below.

To file for Chapter 7 bankruptcy, the debtor must pass the means test, which is the debtor’s average income for the last six months. Suppose that the average is at or below the median state income. In that case, that is step 1 in qualifying for Chapter 7 bankruptcy, assuming there are no issues with non-exempt assets or disposable income.

Chapter 13 bankruptcy requires paying back a portion of the debt. Sometimes, Chapter 13 is referred to as a reorganization. In the Bankruptcy Code, it’s referred to as a “wage earner’s plan” since income is required to qualify, while Chapter 7 is referred to as a liquidation. While the term liquidation refers to Chapter 7 bankruptcy, it doesn’t mean a debtor’s assets are liquidated because the exemptions have to be applied first to see what assets, if any, are not protected.

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One reason Chapter 13 should be filed instead of Chapter 7 bankruptcy is because there is too much disposable income or the debtor failed the means test. Another reason is to protect non-exempt assets.

Maybe the most common reason to file for Chapter 13 bankruptcy is to keep an asset secured by a loan, and the debtor has fallen behind in payments. Usually, it’s related to mortgage payments. With Chapter 13 bankruptcy, the arrears, or the portion the debtor has fallen behind on, are paid back over the next 36-60 months. That option doesn’t exist for Chapter 7 bankruptcy.

Getting Rid of a Mortgage with Chapter 13 Bankruptcy

Is it possible to get rid of a mortgage with Chapter 13 bankruptcy? Yes, but it’s unlikely, but maybe Chapter 13 reduces what is known as a junior lien, meaning a second mortgage.

During the foreclosure crisis, we heard for the first time that mortgages were “underwater” or “upside down,” meaning the mortgage balance was more than the home’s actual value. It’s definitely not the norm. If you think about it, do you know anyone today with a house where the mortgage balance exceeds the home’s value? Probably not, but it was all too common during the mortgage foreclosure crisis.

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When this happened, lawyers argued that the second mortgage should be stripped, meaning it should be reduced to the home’s fair market value, and bankruptcy courts eventually agreed.

For example, your house is valued at $300,000.00, with a $250,000.00 first mortgage and a $25,000.00 second mortgage. In this case, there is nothing to “strip” as the first and second mortgages combined are still less than the home’s value and even has $25,000 in equity.

However, what if the balance on the second mortgage is $75,000.00? Then, by adding both mortgages, the total mortgage balance is $325,000, so $25,000 is “underwater” or has negative equity. In this case, part of the second mortgage can be “stripped,” and now the second mortgage is reduced to $50,000. By adding the first and second mortgages, you will see it equals $300,000, which is the home’s value.

What Happens to the Mortgage That was Stripped?  

The portion of the stripped second mortgage becomes unsecured debt in the Chapter 13 bankruptcy. That means it is treated like other unsecured creditors, for example, a credit card. How much is paid back to unsecured creditors in Chapter 13 bankruptcy depends on the case’s specific facts. Still, whatever the amount is, it would be substantially less than paying the total amount of the second mortgage.

I hope this blog post helped you better understand Chapter 7 versus Chapter 13 bankruptcy. Remember that lien stripping is not an option in Chapter 7 cases.

Please note the information on this site does not constitute legal advice and should be considered for informational purposes only.

Additional blog content is available below:

• Bankruptcy
• Your Wallet

Colleges and universities can purchase my bankruptcy law textbook directly from Routledge Publishing. For paralegals and students buying single copies, you can do so via Amazon books. To access my YouTube channel, click this link.