Updated: Nov 9, 2020
What if some of your preconceived fears and assumptions about mortgage loan investing just weren’t true? Many of my original beliefs about the industry and borrower behaviors have proven to be completely wrong. One of the biggest surprises has been in second liens and reperforming loans. Another eye-opener has been the success I’ve found investing in mortgage loans in active Chapter 13 bankruptcy, the last option for struggling borrowers buried in debt who don’t want to lose their homes.
Understanding Chapter 13
Many people are under the misconception that bankruptcy is the domain of the irresponsible, a belief that could certainly make someone less likely to want to buy a mortgage loan that’s involved in an active bankruptcy.
Sadly, the number one reason for bankruptcy filings is medical debt, which played a role in about 66 percent of bankruptcy cases between 2013 and 2016. While these borrowers may seem like a huge credit risk on paper, they still want and need to keep their homes, which is exactly what Chapter 13 bankruptcy was designed for.
Debtors who file Chapter 13 have regular income, and are given three to seven years to reorganize their financial affairs with a court-approved and monitored repayment plan. Creditors who have a collateralized loan, (like a car or a house) are secured creditors, meaning their debt is secured by lien. Unsecured creditors without collateral in a Chapter 13 case are likely to get a greatly reduced amount repaid in the bankruptcy plan, if anything at all.
Mortgage loan investors are secured creditors, which means their debts are given priority over unsecured debt, and in most cases, the amount owed cannot be reduced. Under the federal bankruptcy code, borrowers who state their intention to retain their residence must normally bring their loan current during their bankruptcy plan. This means making regular payments required under the terms of their loan, plus repaying all arrears (unpaid interest during the period of default).
Borrowers must have their repayment plan (which usually spans sixty months) approved by the court. The goal is to have the borrower exit bankruptcy with their mortgage loan(s) current and in good standing.
Technically, borrowers who complete a Chapter 13 bankruptcy plan and receive a discharge from the court are no longer personally liable for their mortgage debt. Sounds scary, right? Not really, because the lien on the property remains, and the creditor retains the right to foreclose against the collateral property, even if the borrower is no longer personally liable for the debt.
In my experience, the bankruptcy courts are typically debtor-friendly and want to see debtors improve their financial situation in bankruptcy. Remember, any time a borrower’s financial situation improves, it benefits us as secured lienholders, because it means a higher likelihood that borrowers will make on-time payments moving forward after the bankruptcy is discharged or completed.
Bankruptcy can be complicated for the borrower and the borrower’s attorney, but from the creditor’s perspective, it’s relatively straightforward. There are only a couple of filings that creditors are responsible for, and if I don’t like the way I am being treated in a bankruptcy plan, I can always have an attorney file an objection on my behalf.
Also, in most cases, the debtor will be making payments to the bankruptcy trustee, a neutral third party that’s responsible for reviewing the bankruptcy filings and debtor documents to make sure everything is verified and financially feasible. The trustee also usually receives the monthly payments from the debtor and then disburses to the creditors in conjunction with the approved bankruptcy plan.
If borrowers don’t make their required monthly payments, don’t provide everything that’s required by the court, and/or don’t complete their plan, their case is dismissed, and they continue to be personally liable for the original debt without any further bankruptcy protection.
Ultimately, only you, your financial advisor, and your attorney can truly see whether mortgage loans in active Chapter 13 bankruptcy are a good fit for you. I highly recommend you first speak with an experienced bankruptcy attorney to verify all your rights and responsibilities as a creditor.
Keep in mind that the numbers for completing a Chapter 13 bankruptcy plan and receiving a discharge are low. Between 2006 and 2017, only 48 percent of those who filed Chapter 13 completed their plan and were discharged.
Lien Stripping in Chapter 13
There is one situation in which a Chapter 13 bankruptcy can be dangerous for junior lien mortgage loan investors. This occurs when a debtor can prove that a second, or junior, lien is wholly unsecured. This means the collateral property is worth less than the balance of the first lien, with not even one dollar of equity above the first lien.
In this situation, a homeowner filing for bankruptcy can file a motion to remove their second lien. If approved, upon the borrower completing their plan and receiving a discharge, this motion would effectively remove the lien from the property as well as the borrower’s personal liability for the debt, thus rendering the lender’s investment worthless.
To date, I have never had a borrower obtain a lien strip on a second mortgage. One way to prevent this is to check the home’s value and first lien balance to ensure the CLTV is well below 100 percent. The more equity in the property, the less likely a judge will approve a motion to strip the second lien.