Many homeowners are behind in their mortgage payments. Combine that fact with the nationwide decline in housing prices, and it is not startling to see a recent report that nearly 25% of Americans that own a home with a mortgage owe more on the home than it is worth. More than 10% of Americans with a mortgage owe 25% more than the home is worth.
A chapter 13 is a reorganization plan, primarily used by debtors to keep the property they might otherwise lose outside of bankruptcy or in a chapter 7, like a home. Many debtors who are behind on their mortgage use a chapter 13 to stay in their home. As many have grown attached to their home and dont want to deal with moving, they are willing to pay and stay on an underwater home rather than just walk away from the property debt-free in a chapter 7.
The Chapter 13 option is even more palatable to a debtor who gets rid of an underwater 2nd and/or 3rd mortgage in a process called a lien strip. In a lien strip, the bankruptcy judge makes a determination that the home is worth less than the mortgage securing it (presumably just the first mortgage), and therefore all subsequent mortgages are entirely unsecured. As such, the judge issues an order that the entirely unsecured mortgages are to be treated as unsecured mortgages in the chapter 13 plan (the plan consists of monthly payments to the trustee for anywhere from 36 to 60 months), and at the conclusion of the plan the debt on that mortgage is discharged, and the lien is therefore extinguished. Notice that it is contingent upon the plan being completed and the debtor ultimately receiving a discharge.
So for example, a debtor can have a home worth $200,000 with a $220,000 first mortgage balance and a $50,000 second mortgage balance. The debtor can lien strip the second mortgage, so that at the discharge of the chapter 13, the debtor no longer owes on the second mortgage and the lien is extinguished. All the while the debtor has been paying down the balance on the first mortgage, and the home value has possibly been increasing. The debtor might therefore emerge from the chapter 13 with a home that has equity. Had the first mortgage balance been only $195,000, and the second mortgage balance been $75,000, this option would not have been possible. That is because the second mortgage would have been secured to $5,000, even though the mortgages in totality would still equal $270,000.
It is presumptive, yet debatable, that a debtor cannot lien strip in a chapter 7. The 4th and 6th Circuits have ruled this cannot be done in a Chapter 7. No other circuit has issued a ruling, and this issue might ultimately be determined by the U.S. Supreme Court.