As of March 19, 2013, 33% of Chicago-area home mortgages were underwater. This means that 1 in 3 mortgaged homes have negative equity. Some of these homes are underwater because they have more than one mortgage. A common practice during the housing bubble was to issue 100% financing loans. These loans typically funded the entire purchase of a home with no true down payment. 80% of the purchase price was covered by a mortgage (often subprime) and the other 20% was covered by a Home Equity Line of Credit.
Why would someone take such a deal? Most likely, the mortgage broker said that it was possible to refinance into a single fixed-rate loan in 6 months.
When the market collapsed, plummeting prices placed second mortgages entirely underwater. Homeowners who started with 0% equity were now immediately into negative equity. That negative equity then prevented them from getting the refinances that they were promised.
For the most part, keeping a home that is severely underwater is a bad investment. However, the U.S. Bankruptcy Code allows homeowners in a Chapter 13 bankruptcy to strip the junior mortgage liens from their homes if those mortgages completely exceed the value of the home. In more technical terms, a Chapter 13 debtor can strip wholly unsecured junior liens from a home.
When a lien is stripped, the debt associated with that lien is no longer tied to the home. This can bring the underwater home closer to the break-even point. In turn, that might make an otherwise bad investment more worthwhile. Lien stripping doesn't eliminate the debt, however. In a typical Chapter 13, the debtor would pay off a portion of the lien. The actual amount repaid would depend on the individual's assets and disposable monthly income.
So how does lien stripping help someone when the amount to be paid off is rather large? This is where the concept of a "Chapter 20" bankruptcy comes into play. Although federal courts are still a bit split on whether the strategy is permissible, an increasing number of jurisdictions allow the practice.
In a Chapter 20 bankruptcy, the homeowner first files a Chapter 7 bankruptcy. This discharges most debts and severs personal liability on mortgage loans. After the Chapter 7, those mortgages are still attached to the home. However, it is possible to file a Chapter 13 bankruptcy within 4 years of a Chapter 7 discharge. The Chapter 13 filing won't earn a second discharge, but it will allow the homeowner to strip the unsecured second mortgage from the home. In this scenario, it may be possible to repay a much smaller amount on the stripped lien.
Chapter 20 filings are highly technical and fact-specific. They may not be the best plan for everyone. However, they can be a useful tool for restoring equity to a home.