Drop Second Mortgage if Bankrupt? Judge Says No

When Gail and Jared filed Chapter 7 bankruptcy, they owned a home worth about $165,000 that had a first mortgage of $170,842 and a second mortgage of $24,076.

Because they had no equity in the house but wanted to keep it, they asked the U.S. Bankruptcy Court to “strip off” (cancel) the second mortgage, explaining that this would help them get a fresh start, which is the purpose of the bankruptcy law.

But the second mortgage lender protested. Although the home had declined in market value, he argued, it probably would appreciate again, so the second mortgage should remain in place.

If you were the bankruptcy court judge, would you “strip off” the second mortgage from Gail and Jared’s home, because there was no equity?

The judge said no.

There are several Chapter 13 bankruptcy reorganization cases allowing second mortgages to be stripped off when the first mortgage exceeds the property value, the judge explained. But this is a Chapter 7 bankruptcy in which the debtor’s unsecured debts are canceled, he noted.

Both the first and second mortgages on Gail and Jared’s home are consensual loans, the judge said. Because the debtors want to retain the home and although it has no equity, it would be unfair to the second mortgage lender to cancel that loan, he added.

If the home increases in market value, the second mortgage lender should benefit by once again having its lien secured by equity in the house, the judge ruled. Therefore, the second mortgage cannot be canceled in this Chapter 7 bankruptcy proceeding, the judge concluded.

Based on the 1998 U.S. Bankruptcy Court Appellate Panel decision in In Re Laskin, 222 B.R. 872.