What Happens to a Note in Chapter 13 Bankruptcy?
In Chapter 13, the borrower does not automatically lose the home. They can choose to retain the home and continue making mortgage payments. If the debtor wants to keep the collateral securing a particular claim (in this case the home), the plan must provide that the holder of the secured claim (the noteholder) receives at least the value of the collateral.
If the obligation underlying the secured claim was used to buy the collateral and the debt was incurred within certain time frames before the bankruptcy filing, the plan must provide for full payment of the debt, not just the value of the collateral (which may be less due to depreciation).
Payments to certain secured creditors (i.e., the mortgage lender), may be made over the original loan repayment schedule (which may be longer than the plan), so long as any arrearage is made up during the plan.
What Does Chapter 13 Bankruptcy Mean for Note holders?
It can mean a few different things. During Chapter 13, a note holder or lender typically still receives payments from the borrower. In order to remain in the home, the debtor will need to continue making payments on the mortgage. If mortgage payments are not made in a timely fashion, the lender can foreclose and sell the home after requesting and being granted a “motion for relief” from the court.
If the debtor fell behind on mortgage payments prior to filing a Chapter 13, he or she will need to pay off those arrears through the repayment plan created by the trustee. Because of this, the lender cannot foreclose on the home for pre bankruptcy arrears as long as they are being paid off through the bankruptcy plan.
Chapter 13 bankruptcy may delay a foreclosure but will not permanently stop it. This costs a lot in terms of time, lost income, and frustration. The note holder may also incur legal fees in order to defend their claim.
Under Certain Circumstances, Junior Liens Can Become Unsecured
This only happens when the value of the property is not enough to pay senior and junior liens. In essence, no equity. Junior liens can be eliminated or wiped out if there is no equity to support them. The term “wiped” means the loan is no longer valid, and the lender can no longer collect or foreclose. This typically only happens in a Chapter 13, with a few exceptions.
Let’s look at an example. Suppose at the time a borrower files Chapter 13, the home is worth $200,000. It has two secured mortgages on it:
- Mortgage #1: $150,000 (Senior Loan)
- Mortgage #2: $25,000 (Junior Loan)
Total owed on the home: $175,000.
Since the home is worth $200,000, if the home was sold that day, there would be $25,000 of equity above what is owed to both noteholders. In this case, the junior lien cannot be wiped. Let’s look at another example. The same home is worth $200,000.
- Mortgage #1: $200,000 (Senior Loan)
- Mortgage #2: $25,000 (Junior Loan)
In this example, the home has two secured mortgages on it. However, the value of the loans is greater than the value of the property. So in this situation, it is possible for the junior loan to be eliminated if the borrower completes the Chapter 13 plan. The borrower’s attorney would need to file a motion to strip the lien with the court, and then the court would have to approve the motion.
In addition, keep in mind this bankruptcy repayment plan is three to five years long. The borrower must complete the plan fully in order to strip a lien. Most borrowers do not complete Chapter 13 plans. I have heard varying statistics, but a rule of thumb is that somewhere in the range of 70–80 percent of all borrowers who enter into a Chapter 13 never complete their payoff plans. So while junior liens can be stripped, it is by no means a sure thing. It’s actually quite rare. Senior liens, on the other hand, cannot be stripped.
Bankruptcy is a complex proceeding. If you decide to purchase notes on a regular basis, I would encourage you to educate yourself on this topic.
As always, this should not be taken as legal advice, and you should always consult with legal counsel on how to approach any particular situation.
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(This article is an excerpt from Joshua N. Andrews Book titled Paper Profits – How to Buy and Profit from Notes a Beginners Guide)
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