We have been asked this question many times, and this time we like to address this issue in greater details. Let us say you own a home, and if you file for either Chapter 7 or Chapter 13 bankruptcy, what happens to second or third mortgages and liens on your home? This is a very pertinent question as this relate to short sale also. Banks usually approves short sale if there is only loan attached with the collateral i.e house. However, they are reluctant to do short sale if there is home line of equity (HELOC) attached with the property. Banks just cannot foreclose the home unless the join the junion lien interest holder, the second lender. Let us say you own a home and the principal mortgage is $250,000 but you have a second loan and where you own another $100,000. You may have some equity but that may only belongs to the principal mortgage holder. Now, let us see if you file bankruptcy what happens to both of them.
In Nevada, the first principal mortgage is exempted or protected up to the value of $550,000 which is the homestead value. Let us put in other words. Your home is protected up to the value of $550,000 and no lien can take away this much value because it is provided under the Nevada Revised Statutes. Even if you file chapter 7 bankruptcy, this much value is exempted from your creditors. It is advisable to file homestead in Nevada. It does not cost much, probably less than $20 dollar, if you do it yourself. Again, in Chapter 7 bankruptcy, your bankruptcy discharge will eliminate your personal liability on the second mortgage but will not eliminate the lien. In Chapter 13 bankruptcy, you can eliminate both your personal liability and the lien in a procedure called lien stripping. The basic lien stripping rule is: You can eliminate a lien that has no security in the home, but you can’t eliminate the lien if part of it is secured by the home’s value.
Here’s an example. Say your home is worth $210,000, your first mortgage is $205,000, and your second mortgage is $25,000. You can’t strip off the second lien because it is secured by at least $5,000 of your home’s value.
What if a Lien Remains on Your Home After Chapter 7 Bankruptcy?
There is no lien stripping in a Chapter 7 bankruptcy, the lien may have very little effect on your future financial affairs. As we stated, the Chapter 7 bankruptcy will discharge your personal liability for the second mortgage (meaning you can’t be sued for money owed on it). And, absent value in the house securing the second mortgage, the holder wouldn’t benefit from a foreclosure (since all the value of the home would go to the first mortgage holder in a foreclosure sale). Simply speaking, in case of foreclosure the proceeds of the sale would be distributed according to the set of priority rules, and under that the first set of proceeds would go to the principal mortgagor. As we know, there is little or no equity left in our homes these days, so in nutshell, little would be trickled to the second lien holder.
This means there won’t be negative result from the lien remaining on the home after your bankruptcy — unless of course your home’s value comes back to a point that would allow you to sell the home or support a foreclosure action by the second mortgage lender. This is clearly less likely when your home is way underwater (50% is common) than when you are just a tad underwater.
In some cases it needn’t be one choice or the other. It used to be that you could file a Chapter 7 bankruptcy, discharge your personal liabilities and then immediately file a Chapter 13 bankruptcy to strip off the lien. This was called a “Chapter 20” bankruptcy. Now it’s not quite that simple. You are still entitled to file a Chapter 13 bankruptcy right after your Chapter 7 discharge but you won’t qualify for a Chapter 13 discharge. Again, you need to file Chapter 13 in good faith and only if you qualify and submit a realistic plan.