Sometimes it's good to be underwater
No one likes to hear that they have no home equity, or worse, negative home equity.
However, if you have financial problems along with a home equity loan (also known as a second mortgage or second lien), being underwater might get you extra help.
Second mortgages create more problems
If you have financial troubles and are looking for relief, home equity lenders can complicate the short sale or mortgage modification process when they and the primary mortgage holder cannot agree on how much loss each will take on the deal.
In a foreclosure, the second mortgage lender frequently gets nothing from the sale of the property, but it almost never relinquishes its lien without at least some compensation. In a modification scenario, it's the first lien-holder that is reluctant to take a loss unless the second lender also accepts some. While the bickering goes on, the foreclosure proceeds.
How do underwater borrowers make home equity loans disappear?
First, you need to understand the difference between secured and unsecured mortgage debt. Homeowners are finding that they can prevent a foreclosure and reduce their mortgage obligations in the bankruptcy courts.
While the law does not allow bankruptcy judges to modify loans secured by property, a home equity loan is only secured by property when there is sufficient equity to offset the debt. If you have $150,000 of mortgage and only $125,000 of value, there is $25,000 of debt hanging out there--naked, with no equity to protect it. The bankruptcy court says it may be unsecured debt.
Canceling debt isn't easy
Las Vegas bankruptcy attorney Dorothy Bunce of lienstripping.com says it's not that simple--each lender has laws to follow and duties owed to shareholders, employees and other borrowers.
"There is sometimes a perception that the mortgage company is like mean old Mr. Potter in 'It's a Wonderful Life.' Oh, if only George Bailey at the credit union had my note instead, then I could do something about modifying this awful mortgage! But most bankers aren't any more like Mr. Potter than they are like George Bailey. They are human beings caught in a trap of banking laws at both the federal & state levels. In the absence of a bankruptcy, they are limited by law as to the help they can provide their customers."
Home equity lenders can bite you later
Here's why. Even in non-recourse states like California where the first lien-holder must be satisfied with the foreclosure sale proceeds, a home equity lender may have no such constraint. The unpaid debt converts to an unsecured balance, like a really big credit card bill, and the lender can sue you to recover it. What it may do is wait a couple of years until your finances have improved, then sue you and recover the entire balance, plus attorney costs, penalties and interest.
Naked mortgage may be stripped!
Unsecured mortgage debt is treated a lot like a credit card balance--it may be extinguished for nickels on the dollar. So if you can't afford your mortgages plus your other payments, a Chapter 13 bankruptcy may get you out from under.
How does it work?
The judge or trustee examines your finances and determines an affordable monthly payment. You pay this for three to five years, and any remaining unsecured balances, including your home equity debts, are discharged when your plan completes.
It's important to understand that your second mortgage can't be only partially stripped--the home equity balance must equal or exceed the unsecured portion of your total mortgages.
In the example above, the total mortgage debt exceeds the home's value by $25,000. If the second mortgage is $25,000 or less, it's strippable. If it's $25,001, it's not strippable.
Can the threat of bankruptcy force home equity lenders to cooperate in short sales?
It makes sense that a home equity lender would rather make concessions than see its lien stripped from your property, right? You wish!
Arizona bankruptcy lawyer and blogger Joseph C. McDaniel at arizonabankruptcyblog.com explains.
"My experience is that bankruptcy is an ineffective threat with most institutional creditors. The individual who receives the threat is a minimum wage worker, and simply gets to dump the matter on the minimum wage worker tasked with handling bankruptcy. The phrase, 'stop calling me or I'll file a bankruptcy' often draws the response, 'Great! Please make sure I get the case number and date of filing and Chapter so I can move your file off my desk!'"
Moral of the story: Don't threaten unless you're prepared to follow through. You should probably consult a lawyer first so you don't end up with egg on your face.
Chapter 13 bankruptcy: The nuclear option
Bankruptcy isn't something you should undertake lightly, but Chapter 13 can help folks undergoing economic hardship keep their homes, unload second mortgages, establish a manageable debt management plan, and avoid tax liability for forgiven debt.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian, a bankruptcy paralegal and an accountant for Deloitte. She graduated with High Distinction from the University of Nevada with a BS in Financial Management.
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