Depending on whether they are eligible for Chapter 7 bankruptcy or Chapter 13, homeowners who file bankruptcy in California with more than one loan secured by a deed of trust (which include home equity lines) may get very different types of debt relief when it comes to their second mortgage. Upon obtaining a bankruptcy discharge under either chapter, a California homeowner can rest assured that his recourse second mortgage loan will never be able to sue him. This is not the same thing as removing a second lien from the property, however. To understand this distinction requires some explanation of California deed of trust and foreclosure law.
Because residential foreclosures in California are nearly always “nonjudicial” foreclosures (really trustee sales) conducted by the servicer or trustee of the first mortgage lender, California’s anti-deficiency rule prohibits that lender from suing the homeowner for any balance still owed after foreclosing (a “deficiency judgment”). In other words, California homeowners who suffer a foreclosure are generally safe from further collections at least from their first mortgage lender even without filing bankruptcy.
However, second loans are treated differently in California. “Non-purchase-money” loans, such as home equity lines of credit, are treated as “recourse” loans in California, meaning that the lender can sue the borrower on the promissory note even after the home has been foreclosed. This personal liability for recourse second mortgage loans is forever discharged if the homeowner gets a bankruptcy discharge under either Chapter 7 or Chapter 13 bankruptcy.
However, just because the homeowner’s personal liability for a second mortgage or equity line has been discharged, this does not mean that the lender’s lien has been removed from the property. Foreclosing on a lien and suing on a promissory note are two entirely distinct legal remedies. Hence the California homeowner with a second mortgage who obtains a discharge in Chapter 7 bankruptcy will be safe from being sued by the second mortgage lender, but this does not mean that she owns her property free and clear of the second mortgage lien. She will never have to pay that second loan if the property is eventually foreclosed, and she may not have to make a payment on that second loan for as long as she owns the property, assuming the value of the property remains depressed leaving no value for the second lender to foreclose upon. However, because the lien is still attached, she cannot sell or otherwise transfer the property without paying off or settling the second loan.
Chapter 13 bankruptcy, can in certain circumstances, offer the additional benefit of removing the second mortgage lien entirely. If the homeowner has at least some disposable monthly income sufficient to feasibly complete a Chapter 13 bankruptcy plan, and if the property’s value at the time of filing Chapter 13 is less than the amount owed on the first mortgage loan, then the homeowner in Chapter 13 may avoid or “strip off” the second mortgage or equity line entirely. This means the homeowner can emerge from bankruptcy owning his property free and clear of the second loan. He can sell the property, or his heirs can inherit it, without having to negotiate a settlement with the second mortgage lender. When we’re talking about stripping off an equity line of say, $150,000, the advantage offered by Chapter 13 bankruptcy can be enormous if the homeowner desires to keep her home long term.
Even so, many people filing bankruptcy cannot afford to make payments into a Chapter 13 plan. Or their home is not so deeply underwater to qualify for a lien strip of their second mortgage. For them, discharging their personal liability for a second mortgage loan still provides significant debt relief that cannot be overstated. However, their second mortgage lender will still have a valid lien against the property. Although the lender will never be able to sue on that loan, it will be able to hold up an eventual sale or transfer of the property, and could conceivably even foreclose one day if the property ever appreciated to the point that they would get any proceeds from such a foreclosure.
If you’re a homeowner considering filing for bankruptcy in the Bay Area, contact us for a free consultation. We will advise you whether Chapter 7 or Chapter 13 will offer you the best solution for your debts, including a second mortgage or home equity line of credit.