In Chapter 13, however, it is possible to strip off the second mortgage as long as it is wholly unsecured.  What does that mean?  Say you have a home worth $335,000.  First mortgage loan balance is $300,000, while the second mortgage loan balance is $100,000.  This is NOT a wholly unsecured mortgage.  This second mortgage is undersecured, as opposed to unsecured, because the second mortgage lender has a security interest of $35,000.  While it is less than the balance of the loan, some amount is still secured, and there is nothing that can be done here, even with the help of bankruptcy laws, to get rid of that second mortgage.

On the other hand, if the property is worth $335,000, and the first mortgage loan balance is $350,000, no matter what the balance of the second mortgage loan might be, that second mortgage is now wholly unsecured.  There isn’t enough value in the property to cover even the first mortgage, let alone any of the second.  In this scenario, it is possible to treat the second mortgage loan as wholly unsecured in Chapter 13, and upon successful completion of the Chapter 13 plan and an entry of discharge, an order of the court may be sought that clears the lien of the second mortgage as well.

In the above example, it is clear that the second mortgage is wholly unsecured.  In reality, however, not every instance will be as clear.  What if the debtors’ broker says that the property is worth $335,000, as above, but the mortgage lender got its own broker, and according to their broker, the value of the home is $350,001?  If there is even $1 of security for the second mortgage lender, a “strip off” is not possible and the mortgage lien will remain on the property.  What happens in these situations?  Answer: the judge decides.  To do this, the court may need to take evidence from brokers to make a determination of value.

When a second mortgage is stripped, it is treated like other unsecured debts in Chapter 13, meaning, the plan may provide for a repayment of some percentage of the loan, but this could be as low as 5%, or even less.  The key to the strip-off is successful completion of the plan.

How does this happen? There are several ways… It may be that a trade-in was rolled into a new car loan, causing the new loan to be much higher from the beginning. It may be that the term of the loan was longer than the usual 36-48 months, causing a balance to exist as the car nears the end of its useful life. Or it may be that the interest rate on the loan was unusually high, slowing down the pay down of the principal balance.

In any event, what do you do with a car that’s upside down? In a Chapter 7 bankruptcy, one has three options. The first option is to keep making timely payments on the car as always. This would enable the owner to keep their car with no changes to the payment or total amount due. This option may be sensible if one is not behind on the payments and where the negative equity (the “upside down” factor) is not significant.

Another option is to “surrender” the car — simply give it bank to the finance company and walk away. The key difference between doing so while in a Chapter 7 bankruptcy as opposed to a voluntary surrender or repossession is that when done through the bankruptcy the consumer will not be responsible for the difference between the car’s value and the balance of loan. This is called a “deficiency.” In our example above, if the person decided to surrender the 2003 Chevy Blazer without a bankruptcy, the finance company could potentially sue the person for $6,000 — that is the difference between the value of the car, $8,000, and the balance due on the loan, $14,000. However, when a car is surrendered through a bankruptcy, the person will NOT be responsible for any deficiency, which in most cases is discharged along with the other debts.

The third and the most interesting of the options is called “redemption.” This is a right granted by Section 722 of the United States Bankruptcy Code. In short, the section applies to tangible personal property (meaning, it cannot be a house) that is intended primarily for family or household use and that has been exempted or abandoned by the Trustee. In most cases, a family car will be exempted and the Trustee won’t be interested in it.

To redeem something means to pay the finance company the current value of the property in exchange for full ownership. Going back to our 2003 Chevy Blazer example, the finance company MUST release all liens and turn over a clean title to the car upon receiving a payment of $8,000, which is the current value of the car. It does not matter that the balance on the loan is $14,000. The company will have to eat the $6,000 difference and take it as a loss.

One might ask, where does someone going through a bankruptcy get $8,000? Sometimes this money comes from family or friends. For others, certain companies offer special redemption loans to persons going through bankruptcy for this very purpose. In our example, one would get a new loan for $8,000 from one of these companies, essentially refinancing the car for almost half the amount of the prior loan. Naturally, the interest rate on a redemption loan would be higher than regular car loans, but in most cases the monthly payment will be substantially lower than before. In addition, one can do a redemption even if they were many months behind on their car payments, as long as the car has not yet been sold at auction, without being held responsible for the missed payments.

Practically speaking to perform a redemption one has to file a motion with the bankruptcy court and propose a value of the redemption. The financing company can then propose their own value, in which case the judge will decide what the redemption value should be. Even though everyone uses Kelley Blue Book and NADA guides as the standard for determining value, disagreements occur because of issues like mileage, mechanical condition, cosmetic damage, etc. In the end, the redemption price is either agreed upon or court ordered. The process usually takes less than a month from start to finish, and is done seamlessly within the ongoing bankruptcy case.

It must be noted that some attorneys charge extra to do redemptions in addition to their regular Chapter 7 fees. One must consult their attorney fee agreement to see if additional costs will be involved.

In the end, a redemption is an excellent and powerful choice for consumers whose car loans are upside down and who wish to keep their cars. It forces the finance company to accept less than the balance of the loan, a figure based on the car’s current value, which may end up saving the consumer thousands of dollars.

Keep in mind that Federal tax problems usually means that there are also looming state tax issues.

Chapter 13 has a few other important points to keep in mind, and we will visit these in another post.

Most experts agree that recent graduates should invest in a Roth IRA, for which most people qualify. “Giving themselves this kind of head start on saving for retirement will also give these new grads the incentive to contribute year after year going forward. On the other hand, those who do not start a retirement plan at this stage are more likely to put it off for another year, then another,” says Dmitry Lev, a consumer bankruptcy and tax attorney based in Boston. If an investor begins contributing the current annual maximum ($4,000) early in his career, he will easily have $1 million by retirement, if not sooner, says Lev.

To expand on the issues raised in the article — first of all — what a dilemma: how to spend bonus money! But the same concepts I suggested for new business school grads are still sensible advice whenever a person walks into a not-so-small (and not-so-big) lump sum of money. This can happen unexpectedly, on a happy occasion, such as winning the lottery, or on a solemn note, like a small inheritance or a life insurance policy payment upon a passing of a family member.

My first suggestion to new grads and others alike, assuming there is no pressing financial emergency or overwhelming debt, is to invest in a Roth IRA. As I suggested in the article, disciplined annual Roth IRA contributions lead to great rewards with little required effort. And this is without considering the employer sponsored 401k type retirement plans, where regular contributions pay off even more with benefits like matching. Yes, I am advocating that anyone who qualifies should contribute to both their employers’ 401k plans and Roth IRAs.

Clearly if a person is driving a clunker and needs a new set of wheels to get to work, this is a necessary expense. But instead of buying a brand new $50,000 Lexus and financing it for 8 years, a more sensible approach would be to purchase a sub-$15,000 car, which would be sufficient (though not extravagant) for most, and finance it for no longer than 3 years. My personal rule of thumb is that if one cannot afford monthly payments based on a 3 year car loan, then they cannot afford that car at that price.

For most students, paying off their student loans at once is probably not a good idea. Federal student loans have relatively low interest rates, and for that reason they are “good debt” rather than bad debt. Certain private student loans may carry significantly higher rates, and these should be paid down sooner.

In short, there is no better time to learn about the rewards of delayed gratification than when a new grad receives a chunk of money in hand. That money will take our grad much further and last him or her much longer if it is not immediately spent on the luxuries of “starting a new life.”

Attorney Dmitry Lev assists persons seeking Bankruptcy protection in Massachusetts. In addition, Attorney Lev counsels and represents persons in taxation matters with the IRS and state agencies, and victims of unfair debt collection practices. Law Offices of D. Lev may be reached at (617) 556-9990 for a free consultation regarding a specific matter.