Stripping Off Junior Liens

One of the commonly known facts about bankruptcy is that in general you cannot modify a mortgage secured by your principal residence. This means that if you have an adjustable rate mortgage and the rate is going from 5% to 13% and your payment is going from $1500 to $2500, you generally can’t change that by filing a bankruptcy. However, there is one option that has been irrelevant for the last several years due to the hot real estate market.

If a junior mortgage is wholly unsecured, i.e., there is no equity for that mortgage, the wholly unsecured mortgage may be stripped off and treated as an unsecured claim. Thus, if a house has a value of $200,000 and there are two deeds of trust, one on which there is $205,000 owing and one on which there is $40,000 owing. The second deed of trust with $40,000 owing could be stripped off and treated as an unsecured claim. In a Chapter 13 plan, this might mean that the $40,000 deed of trust could get nothing if the plan pays 0% to unsecured creditors.

With real estate values rising by 25% a year in the first five years of this decade, there were no opportunities to strip off mortgages, because all mortgages were at least partially secured. With some of the risky lending practices that were being used (100% financing and even 125% financing), however, that is changing now. A house that was 100% financed with two mortgages (80% and 20%) might be worth 80% of what it was worth when it was financed. Thus, the 20% mortgage might be stripped off and treated as unsecured.

This is an important right for debtors to consider in deciding whether they will be able to keep their home.