Lien Stripping for Personal Residences

April 13, 2006

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When battling liens against you, it's important to note that lien stripping is not available for a lien secured solely by a personal residence. This provision was added to the bankruptcy law in 1994.

During the late 1980s, a secondary market developed for mortgages: Banks would write mortgages, and then sell the mortgages to investment companies that, in turn, would sell stock to investors. In effect, investors would buy into the mortgages, and the mortgages would be traded as securities, similar to stocks and bonds.

Congress clearly had these investors, and not debtors, in mind when it added this restriction on lien stripping for personal residence loans. The intent here is to prevent debtors in bankruptcy from voiding any portion of a lien on a mortgage, even when the amount owed on the loan greatly exceeds the value of the residence, and when the owner intends on keeping the home. The result is that the full amount of the loan must be repaid. (Of course, if the owner gives up the home, the excess debt above the value of the home will be discharged as unsecured.)

In doing this, Congress intended to make the market for the mortgages more secure and thus more attractive to investors. Thus, a so-called "125 percent home equity mortgage"--wherein a homeowner borrows, against the home, 100 percent of its value, plus an additional 25 percent--represents an extremely risky way to finance a business.

Warning

The small business owner will frequently consider funding a business through a second mortgage, or a refinancing, on a personal residence. However, because of the previously stated provision, you would be wise to heed this advice: Don't do it, or at least do it only after serious consideration of the possible consequences.

Specifically, consider this option only if you are completely sure you can pay the mortgage (without a return from your business) or you are prepared in the event that you lose your house. Here, in a worst-case scenario, the small business owner would lose the home to foreclosure. You could then file a Chapter 7 bankruptcy proceeding to eliminate any deficiency (balance left after sale of the home), and thus be completely free of any remaining portion of the mortgage.

Clearly, if you had a spouse, children, pets, etc., you would be taking a significant risk here unless you were completely sure you could pay the loan.

The risks of home loss would not be as great for a single person who could easily move to an apartment, or a family that could easily move into a home supplied by a relative.

The rule to remember is this: Be prepared to pay the full balance of the mortgages, or you will lose your home.

Despite the general rule, two exceptions may apply so as to allow lien stripping of a mortgage on a personal residence:

Loans based on a home plus other collateral. Lien stripping is prevented only when the lien is secured "solely" by a personal residence. Court decisions have made it clear that when the debtor has given other collateral (in addition to the personal residence; e.g., office equipment) as security for the mortgage, lien stripping will be allowed. Thus, if you will be taking out a second mortgage or refinancing your home, you should consider offering additional collateral, such as furniture, as security for the loan. This can be done under the guise of seeking better terms from the lender, such as a lower interest rate.
Some second mortgages. Many (but not all) bankruptcy courts follow a rule that makes a second mortgage totally unsecured if the first mortgage balance equals or exceeds the value of the personal residence. This exception will not apply in the case of a refinancing of a mortgage, since in a refinancing the new mortgage pays off the first mortgage. The exception is predicated on there being two distinct mortgages (a first and a second mortgage). For this reason, if you have the option of financing your business through a second mortgage or refinancing your first mortgage, the second mortgage may be the better choice, especially where the amount of the first mortgage is close to the value of the home.

In addition, remember that the general rule applies only to a lien secured solely by a personal residence. Thus, lien stripping will be allowed for a mortgage on a building used in a business.

Work Smart

If you own a small business, you must consider a number of different factors in deciding how to finance it. Be especially wary of misleading advertisements regarding second mortgages or refinancing.

When financing a business, a second mortgage or refinancing can offer a lower interest rate than a credit card. However, this is not always the case, and there are other considerations. For a "125 percent home equity" loan, expect to see an interest rate double the rate available on a conventional mortgage.

Even where the rate on a new mortgage is lower than that on a credit card, you need to weigh this benefit against the risks engendered by the mortgage: Credit card debt is unsecured and fully dischargeable in a bankruptcy proceeding, while the mortgage, of course, is not.

Furthermore, while most home mortgage interest is deductible if you itemize deductions on your tax return, IRS rules provide that the mortgage interest is only deductible to the extent it is attributable to the value of the property. If you take out mortgages or home equity loans that exceed the value of the property, interest on the excess portion of the loans is not deductible. Thus, in a 125 percent loan, only ¹⁰⁰/₁₂₅ (80 percent) of the interest is deductible.

A second mortgage or refinancing to consolidate bills does not save you money by eliminating bills. They merely substitute one bill for others. While your monthly bills may well be lower than the bills they replace, they are paid over a longer period of time. This will usually cost you more money because interest, usually at a high rate, will apply for a much longer period.

Overall, however, the inability to strip and thus reduce the lien, or eliminate the lien against a homestead exemption, in or out of bankruptcy, is one of the most important factors to consider. This factor, alone, should give you pause before considering a second mortgage or refinancing as a source of funding for a business. A conventional second mortgage, which when added to the first mortgage typically doesn't exceed 80 to 90 percent of the value of the home, may offer advantages, including a low interest rate, low monthly payments and a tax deduction for the interest paid. These advantages must be weighed against the risk of foreclosure and loss of the home.

There is one other situation where a second mortgage on a home may represent an excellent exemption planning strategy: namely, where the value of the home exceeds the amount of the homestead exemption in your state. In that case, a second mortgage can bring your equity in the home below the exemption amount, thus making the home judgment-proof. Even here, however, all of the above factors must still be weighed against the benefits of this form of exemption planning. In this respect, a 125 percent home equity loan presents a very risky alternative. A conventional second mortgage, however, might be an attractive choice in this situation.