In an unanimous decision by the Supreme Court of the United States, a decision was passed down that prevents a debtor in a Chapter 7 bankruptcy proceeding from voiding a junior mortgage (or second mortgage) if the debt on a senior (or first) mortgage exceeds the current value of the home or collateral. This is in effect when the claim by the creditor is secured with a lien and allowed in the code.
This means that the junior mortgage is not considered an “unsecured” loan, and will not be permitted to be discharged in a bankruptcy proceeding. This will primarily benefit commercial lenders, and will allow junior lien holders to collect on loans in the event that a debtor files for bankruptcy.
In its decision, the court ruled for Bank of America against two debtors – Edelmiro Toledo-Cardona and David Caulkett – who wanted to pay off their junior loans out of the money borrowed in second loans. The ruling by the Supreme Court reverses a 2014 decision that would allow the stripping off of the second mortgages where the first mortgage is under-secured at the time of the bankruptcy. The lien holders argued that the 2014 decision would allow debtors to void certain liens on their homes.
Judge Clarence Thomas wrote that this interpretation on the code would be difficult to apply to the framework of bankruptcy, given the fluctuating state of the real-estate markets. Justice Thomas writes, “Given the constantly shifting value of real property, this reading could lead to arbitrary results.”
Tension Between First and Second Mortgage Holders
While voiding a junior lien can make it easier for a primary mortgage holder to sell a property it can be a great economic worry for junior lien holders. A decision against the second mortgage holder could inflate the prices of credit across much of the economy.
With many housing markets on the upswing after the doldrums of the 2008 slump, houses need only appreciate a few thousand dollars for many second mortgages to be in the money. Simply discharging those loans would make it more difficult for future consumers to acquire second mortgages, as they would be considered too high a risk for lenders to take.
What This Means For Future Bankruptcy Cases
If you declare bankruptcy and have a senior and junior loan, and you declare bankruptcy, you may not be able to discharge a second mortgage, even if the collateral is not worth the amount left on the loan. You may only prevail if the lien holder is not secured according to the rules of the court, since in that case, the value of the lien to the bank would be zero.
However, in most junior or second mortgages, the loans are secured and cannot be stripped or made void in a bankruptcy proceeding.
This only seems to be in effect for Chapter 7 proceedings as it has been stated that this ruling does not effect Chapter 13 bankruptcies.