Lien stripping allows the borrower to get rid of any “wholly unsecured” liens on their property. When a mortgage or lien is put on a borrower’s house, its priority against other liens is usually determined by when the lien was recorded with the county. For the most part, the earlier recorded lien has priority over any subsequent liens. So if the house gets foreclosed on, the first mortgage lender gets paid first from the sale proceeds, and, if there are any additional proceeds, the lender on the second mortgage will get any surplus funds.
In many cases, if the borrower owes more on their first mortgage than the fair market value of their house, the equity of the property is considered, “underwater” and the second mortgage lender wouldn’t receive anything from the foreclosure because there’d be nothing left over after the first mortgage is paid. If the second mortgage lender doesn’t get any money after the house is sold, the second mortgage is considered “wholly unsecured” and can be stripped through a Chapter 13 bankruptcy.
"Lien Stripping" is a process available primarily in Chapter 13 bankruptcy that can remove junior liens (second or third mortgages) and make the debt "unsecured".
Example. Say a house is worth $300,000 and the borrower has a $350,000 first mortgage and a $50,000 second mortgage. In a Chapter 13, the attorney for the borrower would ask the court to “strip” the second mortgage since there wouldn’t be enough in a foreclosure to cover the first mortgage.
What Happens To Stripped Liens?
The stripped liens will receive the same treatment as any other unsecured debts (such as credit cards) in the bankruptcy. These debts usually receive nothing or a small amount and get discharged (wiped out) at the completion of the Chapter 13 bankruptcy. After the discharge, the lender for the stripped lien is required to remove their lien from the borrower’s house.
No Stripping Allowed
As of June 1, 2015, the United States Supreme Court decided that a Chapter 7 bankruptcy debtor cannot “strip off” a junior lien. Lien stripping takes place when there are two or more liens on a property, and the senior lien is “underwater” in that the amount owed on the senior lien is greater than the value of the property. In a Chapter 13 case a property owner can strip off the junior lien, resulting in it being treated as unsecured debt in the bankruptcy.
The ruling says that bankruptcy courts may not “strip off” junior liens on property if the value of the property used as collateral is less than the amount the debtor owes to the senior lienholder — in other words, the junior mortgage lien is “completely underwater.”
The Court’s unanimous ruling impacts the right of junior lienholders to collect on loans in the event of a debtor’s declaration of bankruptcy and the treatment of previously secured, but subordinate, debt in bankruptcy proceedings.