Getting Rid of a HELOC in Bankruptcy

Ok, pop quiz time. For those of you that are familiar with the term HELOC (Home Equity Line of Credit), please answer the following question:

A HELOC is most similar to:

1. A Credit Card (or other unsecured debt)
2. A Home Mortgage (debt secured by home equity)
3. A man that comes and opens your doors when you have lost your keys
4. All of the above

Any guesses? Anybody? That’s right, B: A Home Mortgage (debt secured by home equity). Because a HELOC is a secured debt, it is handled differently than credit cards or other unsecured debt in bankruptcy. I am asked at least weekly by chapter 7 bankruptcy clients to discharge liability associated with HELOCs. Unfortunately, this isn’t possible if you plan on keeping your home.

Let’s refresh our memories a little. A secured debt is one in which the creditor has rights in the security (think collateral property – something that the creditor can take in the event of default) and against the debtor in the form of personal liability (think lawsuit – the creditor can file suit against a individual that defaults on a loan).

Let’s consider a standard car loan. These are secured loans which means that, if you read above, you know that there are two ways the creditor is protected. One way is by your personal liability towards the loan. If the car is taken by aliens – and your insurance won’t cover it – you are still liable for the debt. The second protection is via the car itself. In this scenario, the security or the collateral is the automobile and thus the creditor can repossess the car when the loan is defaulted on. 

Thus while chapter 7 bankruptcy may discharge any personal liability associated with the HELOC, the lien against the property will pass through the bankruptcy intact. This is a problem only if you are planning on keeping the home. If you are forfeiting the property in bankruptcy, the presence of that lien is likely inconsequential.

However, there are solutions for dealing with an burdensome HELOC while keeping the home. The first option involves bankruptcy and can thus be useful in eliminating other debts. Keep in mind that the second and third options are not compatible with bankruptcy.

1. Chapter 13 Bankruptcy: It is pretty common today for an individual to lack any equity in their home. We can thank falling home prices and over exuberant lending for that. If your home is currently underwater, you may be able to strip your HELOC of its secured status via lien stripping. This converts the HELOC to an unsecured debt, for which personal liability will be eliminated upon discharge. What is the catch? Well, there are two biggies that comes to mind:
   1. In order to qualify for stripping a lien must be wholly unsecured by equity in the collateral property. Huh? Basically, your primary mortgage (or the combination of mortgages that are of higher standing than the HELOC) must exceed the current appraised home value.
   2. Chapter 13 bankruptcy requires that contribute a monthly payment to the bankruptcy estate for a period of 3-5 years. This means you must have disposable income in excess of your monthly expenses to contribute.
2. Settle with the Lender Holding the Line of Credit: Recently, I have heard many stories of potential clients settling the second mortgage by offering a lump sum payments that amounts to a fraction of the total loan value. Why will lenders accept such offers? Lenders are also affected by falling home prices, and it is not uncommon for a second mortgage holder on a foreclosed home to receive nothing upon its sale. This is because proceeds are used to pay primary mortgage holders first. However, many negotiations require payments to be made in a single lump sum, which can be difficult for many people.
3. Modify the Line of Credit Payment: If you are upside down on the property, you could negotiate a modification with the lender. The line-of-credit lender would rather receive something that be forced to write off another loan. You may be in a position to negotiate your monthly payments with the lender.

Managing unaffordable HELOCs can be difficult. This is why I often cringe when I hear of somebody applying for such a loan, especially if they are using it to catch up on other bills. One of the most frustrating scenarios I encounter is when debtors have previously taken out a large HELOC in an attempt to catch up on credit cards, only to resort to bankruptcy somewhere down the road.

If they would have come to me prior to rearranging their loans, I could have easily eliminated their unsecured debt via chapter 7 bankruptcy. However, by trading unsecured debt for secured debt, the situation becomes significantly more complicated.