You can wipe out many of your debts by filing bankruptcy, but not your secured debts. Debts secured by a lien on your property, such as a car loan, a home mortgage or a second mortgage, survive bankruptcy intact. Section 506 of the Bankruptcy Code provides an exception you can use to remove some of those liens and reduce your debt burden.
Federal bankruptcy law is covered in Title 11 of the U.S. Code. Section 506 says that if a creditor has a claim greater than his interest in the debtor's property, the claim is unsecured. For example, if you have a $150,000 mortgage and a $50,000 second mortgage on a house that's now worth $125,000, the first mortgage covers the entire value of the house. Under Section 506, the second mortgage isn't a secured claim because there's nothing left to attach a lien to.
In Chapter 13 bankruptcy, you pay off some of your debts over three or five years. Debts you can't discharge, such as secured debts, alimony and most back taxes, have to be paid in full, while unsecured creditors receive only partial payment. If you show the bankruptcy judge that some of your liens are unsecured, the judge may agree to strip the lien. If the court strips a second mortgage, the lender becomes an unsecured creditor and you no longer have to pay the whole debt.
If the lien is on a car, a boat, or any property other than your house, you may be able to strip even more of your debt away. Suppose your car is worth $8,000, but you still owe $9,500 on the loan. Under section 506, the court can cut your secured debt down to $8,000, stripping away $1,500. Bankruptcy law says that Section 506 doesn't apply to vehicles purchased within 910 days of filing bankruptcy, but some courts have used Section 506 to strip such liens just the same.
You can use Section 506 to strip liens in Chapter 13 and Chapter 11 -- business reorganization bankruptcy -- but not Chapter 7. In Chapter 7 you liquidate your assets to pay your creditors; if you can't pay a debt secured by a lien, you have to give up the property. In May 2012, the 11th Circuit Bankruptcy Court ruled that bankrupt debtors can strip completely unsecured liens in Chapter 7 bankruptcies, just like in Chapter 13. The Nolo legal website, however, predicts the Supreme Court will eventually review the case.
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- How Does Chapter 7 Work?