The Magic of Chapter 13
Eliminate 2nd (and 3rd ) Mortgages
Modify 1st Mortgages
Cancel All Credit Cards
Pay A Car at What It’s Worth, Not What Is Owed
I have bad news. I have good news.
The bad news is that home values have seriously declined -- as much as 50% in the far suburbs.
The good news is that this is the perfect time to eliminate second (and third) mortgages on homes, as well as modify the first mortgage, cancel credit cards, and reduce car loans to what the car is worth using the power of Chapter 13 bankruptcy.
Questions and Answers
What is Chapter 13 bankruptcy?
Chapter 13 is very different and much more powerful than the common Chapter 7 most people are familiar with. Chapter 7 is a liquidation. In effect, the debtor says to the court: “This is what I owe. This is what I own. Please discharge me of what I owe and I will give up what I own.” Of course, in most Chapter 7 cases, if evaluated carefully by the attorney, the person loses nothing because any property having value will be protected by the exemptions allowed under state law that avoid leaving persons destitute. Any other property the person has will be worth less than the loans on it, and hence of no value in the bankruptcy.
How is Chapter 13 different?
Chapter 13, or the other hand, is a reorganization bankruptcy. The person is granted extraordinarily powerful rights that he does not have in Chapter 7. Among the most important is the power to force modifications of specific types of loans without the consent of lenders. For the person who wants to keep particular collateral such as a house, car, or equipment, one of the primary goals in any Chapter 13 case will be to modify such loans by reducing the total loan balance to the current value of the collateral, reduce the loan’s interest rate to just-above-market rate, and change the term (length of loan payment plan) to make payments more affordable.
How does it work?
In Chapter 13, the person gathers and discloses all financial information including assets, liabilities, income, expenses and any recent transfers of property. Then, within the rules of Chapter 13, the person proposes a plan of reorganization in which he indicates what he will do about his debts, including what modifications he proposes to loans securing collateral, as well as the monthly payment he thinks he can make comfortably during the 3 to 5 year term of the plan and which meets the minimum requirements of the law.
Can you give me an example of how a typical Chapter 13 works?
This is a fairly typical scenario. The person has a house he bought under a so-called “80/20” plan for $500,000 in 2006 that is now worth $350,000. The balance and payments on the first and second mortgages are, respectively: $400,000 at 8% (PITI = $3,200) and $100,000 at 10% ($878/month). He owes $18,000 in arrears on his first mortgage. In addition, he has a car he bought in 2005 and on which he owes $25,000 at 10% interest ($532/month), which is now worth $8,000. He has amassed $50,000 in debt on credit cards, personal loans, and bills on which he makes the minimum payment of $700/month. His income has gone down, but he would like to keep his car and his house if he can find an affordable way to do it.
For this person, a plan would be proposed that consists of the following:
- Modify the 2nd mortgage and change it to an unsecured debt (similar to the credit cards, bills, etc.)
- Modify the car loan car reducing the balance to the $8,000 current value of the car and interest rate to prime rate plus one (5%).
- Pay all unsecured creditors a dividend of 2%, which is as much as he can comfortably afford.
Before the Chapter 13, the person’s monthly payments on debt looked like this:
After the Chapter 13 plan is confirmed by the court, payments would look like this:
|2nd mortgage:||- 0 -|
|Car:||- 0 -|
|Unsecured debt:||- 0 -|
Ch. 13 Plan Payment: $168/month (= $151 (modified car loan) + $17 (dividend for unsecured debts))
NEW TOTAL: $3,368/month
Furthermore, once the person completes his plan and gets a discharge order from the court, he will have reduced his original overall debt as follows:
|2nd mortgage loan:||- $100,000|
|Balance of car loan:||- $17,000|
|Unsecured debt:||- $50,000|
|TOTAL SAVINGS:||- $167,000|
What are the advantages?
Through the reorganization, the person has held on to collateral he wished to keep and made his monthly payments affordable. He reduced the car loan to current value, and brought down his interest rate, effectively cutting his monthly car payment from $532 to $151 -- a savings of $381/month. He reduced the total debt against the house by $100,000 and brought the total debt much closer to the actual value of the house. Total monthly cash outflow was reduced by $1,942/month, however, the person still lives in the same house and drives the same car.
In his example, why not also reduce the first mortgage by $50,000 from $400,000 to the actual $350,000 value of the house?
As of the time of this writing, there is still an important legal restriction on the power of Chapter 13 to modify mortgages. Current law states that a Chapter 13 plan can propose the modification of secured debts except a debt “secured only by a security interest in real property that is the debtor’s principal residence.” (Emphasis added.)
Pay close attention to the wording of this prohibition and, in particular, the underlined words. The courts have read this statute very narrowly such that situations outside the wording are very important and widely-employed exceptions to the rule.
Can you give me an example of an exception?
The most important exception involves the word “secured.” For most bankruptcy courts, including the bankruptcy courts of Maryland and Virginia, a mortgage that is not secured at all, such as a second (and third) mortgage on property that has devalued below the balance of the first mortgage, is not protected by the prohibition and therefore can be modified in Chapter 13. Among bankruptcy lawyers, eliminating unsecured mortgages liens is known as a “strip off” and is done frequently in cases worked by this office. That is precisely what was done to the second mortgage in the first example of this Q&A.
Any other important exceptions?
Yes, the exception to the prohibition on home mortgage modification does not apply to rental property (since the loan is not on the principal residence of the debtor). In Chapter 13 the person has the right to modify mortgages on rental property by reducing it to the value of the property as well as bring the interest rate down to just-above-prime rate. However, other law in bankruptcy requires that the loan, as modified, must be paid in full during the term of the plan, which legally cannot extend more than 5 years, which often makes this modification impracticable.
Are there instances when a modification of a loan on a rental property could be feasible?
Yes, but generally it would have to be in situations where the value of the property has depreciated so much that the whole loan could be paid in 5 years. In fact, for some condos, in certain local areas, that is the case.
In particular, this type of modification in bankruptcy will work for the person who has “lent credit” to another such that the person living in the house is actually a renter to the person who “lent credit” to the other.
In one case reviewed by this office a daughter “lent” her credit to her mother so that she could buy a condo. The condo was purchased for $270,000, but had depreciated to $70,000. Payments were $2,200/month. The mother could not pay and the property was ready to go to foreclosure. The foreclosure would be stopped immediately upon filing of the Chapter 13. The loan would be modified and the lender forced to take the value of the house, $70,000, at approximately prime plus one (5%). Payments would drop to approximately $1,400/month, and the residence would be fully paid off in 5 years, as opposed to 30 years, saving hundreds of thousands of dollars in interest over that time.
In many ways, this is tantamount to purchasing the property, at a bargain price, with financing terms they could never qualify for if they were taking out a new loan, given the applicants seriously damaged credit score.
Other important exceptions to the restriction on principal residence mortgage modifications involve:
- Mobile homes. (Most courts, including the Court of Appeals for the 4th Circuit which covers MD and VA, do not consider a mobile home to be “real property” and hence not subject to the principal residence loan modification prohibition.)
- Home loans that are secured not only by the home but also by other real estate or personal property. (This loan would not be secured “only” by the principal residence.)
- Liens against the principal residence that are not a “security interest” (consensual liens) within the meaning of the bankruptcy code such as tax liens, judgment liens, or mechanics liens.
- Liens for loans that will mature before the end of the Chapter 13 plan. (This is a rare situation, but is intended to help a person who almost has his house paid off.)
What, then, can be done with the first mortgage on a principal residence if it cannot be forcibly modified in Chapter 13?
There are still other options. For example, nothing in the law bars a lender from working out a voluntary modification with the home owner, and, in fact, some of our clients have done that. The Obama plan encourages modification in bankruptcy. The loan principal usually is not reduced, but the lender may voluntarily reduce the interest rate or, in the case of adjustable mortgages, convert the loan to a fixed, 30-year mortgage. Finally, if the home owner wants to take a particularly aggressive position and the loan has legal defects, such as Truth in Lending or Real Estate Settlement Procedures Act violations, the violations can be litigated in the bankruptcy court and used as leverage to force a settlement for a more favorable modification.
How does Chapter 13 compare to a loan modification?
You must keep in mind that both options can be pursued. It is not an “either/or” situation. They are not mutually exclusive. A loan modification can be pursued during the bankruptcy, while under the protection of the court, or even after you have been rejected for a modification you could afford. (You can always reapply for a modification.) The truth is most people will be better candidates for modification during or after the bankruptcy because their overall debt-to- income ratio, an important factor banks take into account, will improve – the applicants will not have the monthly obligations associated with 2nd mortgages, car payments, or credit cards. Finally, while modifications are purely voluntary on the part of the lender, modifications in bankruptcy are not. There is a very clear set of rules under which modifications are determined by the court and which mortgage lenders are obligated to respect.
What did you mean “as of the time of this writing” when referring to the current restriction on mortgage modifications on a principal residence in bankruptcy?
A bill backed by President Obama (and the National Association of Consumer Bankruptcy Attorneys on whose behalf this office advocated to lawmakers) which would have granted bankruptcy judges more powers to re-write home mortgages passed the House of Representatives in April, 2009 but then was defeated in the Senate. Again, late in 2009 the bill was re-introduced, but failed to pass the House. When the bill was re-introduced the second time, there was talk on Capitol Hill to bring the bill back for another vote because of the fact that voluntary mortgage modifications by mortgage lenders are not reaching enough homeowners in distress. If the bill had passed, homeowners would have been able to not only “strip off” the second mortgage, but also then reduce the balance on the first mortgage to the current value of the property (through a process known as a "strip down" or "cram down").This is relief debt-saddled homeowners want and which is desperately needed to stem the tide of abandoned homes. Almost one-quarter of homes nationally are worth less than the mortgage debt, and that fact is certainly one big incentive driving homeowners to give the property up to the bank. The prospects for this proposal becoming law are not good at this time, but keep an eye on further developments.
Chapter 13 presents another option for the person who is in financial distress, wishes to keep the collateral securing his debts (such a house or car), and make payments affordable while, in many cases, eliminating some of the debt on that property.