How to Reduce Your Mortgage in a Chapter 13

When people file for Chapter 13 bankruptcy, their debts typically exceed their monthly income and they can no longer pay their mortgage and other bills. Fortunately, in filing for bankruptcy protection, consumers can reorganize and pay down their debts and possibly reduce their overall mortgage liability.

In a Chapter 13 bankruptcy, you are placed on a three- to five-year repayment plan in which you make payments to your creditors. If you make your payments according to the plan rules, your creditors are not able to take any actions against you to recover your debt. This means that your mortgage lender is not allowed to sue you or foreclose on your home.

Read More: Chapter 13 Bankruptcy Explained

The most obvious way to reduce your mortgage while in a Chapter 13 plan is to pay down your mortgage while under bankruptcy protection. Since your creditors are not permitted to impose penalty interest rates or late fees while you are in bankruptcy, you are paying down the principle owed to your lenders. Therefore, if you meet your payment obligations, you will likely emerge from bankruptcy with no credit card or other consumer debt and will have reduced your mortgage balance through the repayment plan.

When you attach a primary or second mortgage to your home, the lender secures its loan by placing a lien against your property. The security created by this lien prevents your mortgage from being discharged by your bankruptcy. However, if the value of your home is less than what you owe on your primary mortgage, you may be able to strip any liens attached by a second mortgage or home equity line of credit. Lien stripping only applies to your principle residence, not a vacation home or investment property.

For example, if your home is worth $300,000 and you have a primary mortgage of $350,000 and second mortgage of $50,000, your house's value would not cover the debt owed on both loans. Therefore, since the primary mortgage has priority over the second mortgage and would use up the entire value of your property if there were a foreclosure sale, the second mortgage is wholly unsecured. In this situation, the bankruptcy court may have authority to strip the second mortgage's lien on your property and discharge the second mortgage loan when your bankruptcy case concludes.

You may be able to reduce a mortgage on an investment property through a process called a "cram-down," where the bankruptcy court may reduce the outstanding loan balance and interest rate on the debt. In order for a cram-down to be implemented, the amount of the loan must exceed the value of the property. The court would reduce the loan balance to an amount equal to its present value and you would be required to pay off the newly crammed-down loan balance by the end of your bankruptcy case. The court could also reduce the interest rate on the loan to current market rates, or another reasonable rate.

In order for a cram-down to be granted, you must have external funding available to pay off the property during the bankruptcy so that you are not committing funds to the investment property that could otherwise go to your other creditors. For example, if you owed a mortgage on a rental property that you could not find a renter for prior to filing for bankruptcy, but were able to find a tenant after filing for bankruptcy, you could commit this new income to fund a cram-down repayment.