Avoid foreclosure, eliminate the second mortgage
Is your house underwater?
Tess Vigeland: I'll make an educated guess that we're gonna get some reaction to this next story. Anytime we feature a way for someone to get out from under a crushing debt burden, we get letters about how people should be responsible for their debts and should have to pay them. That said, this is about an element of the bankruptcy code that allows borrowers to discharge what's called a second, or "piggyback," mortgage. And it potentially allows those people to stay in their homes instead of losing them.
Marketplace's Jennifer Collins reports.
Jennifer Collins: There are signs of financial trouble all over Leif Madsen's house, a five-bedroom in a Denver suburb. There's not much furniture and...
Leif Madsen: Broken window from a flying toy, taped up right now.
The lawn has taken a beating from four kids with a football.
Kids shouting in the yard
Madsen: We've kind of neglected our yard. But that's because we were living with uncertainty for the past four years in the middle of this process.
That process began when Madsen lost his job in 2007, and then nearly lost his $300,000 home. He eventually filed for bankruptcy -- that let him keep the house while he worked out a payment plan for his debts. Under a little known provision in the bankruptcy code, Madsen may also be able to get out of paying his second mortgage.
Ike Shulman is co-founder of the National Association of Consumer Bankruptcy Attorneys.
Ike Shulman: For people who hear about it for the first time, it's like somebody just told them they can save their home.
I'll explain in a minute how Madsen may be able to wipe away a $30,000 second mortgage. But first, a reminder of how he and lots of other people got into trouble in the first place: During the housing boom, banks were doling out mortgages and credit for the asking. And millions of people bought homes they couldn't afford and then borrowed against them by taking out second mortgages or home equity lines of credit. It was easy because banks believed home values -- and home equity -- would keep rising.
Richard Green: Yeah, they were pretty dumb loans. Here we had an industry develop around people not having equity in their house.
That's Richard Green, director of the Lusk Center for Real Estate at the University of Southern California. We all know what happened next: The housing market crashed and people owed more than their houses were worth. Which brings us back to Madsen: He took out a $30,000 second mortgage to make the downpayment on his house -- meaning he went into debt for nearly the entire price of the home.
Madsen: When I signed off on the paperwork, I said, "Are we going to be able to do this?" 'Cause I really wasn't sure.
No, he wasn't able to. His adjustable-rate first mortgage -- which started out at $1,500 a month -- doubled. Meanwhile, the value of his house dropped 20 percent -- meaning there was no equity backing the second mortgage. Plus, he ran up $10,000 dollars in credit card debt trying to cover his bill while he was unemployed.
Madsen: Bankruptcy suddenly becomes the only realistic way to say, "I can get out of debt. I can suffer with my credit thing. And then I learn my lesson."
Under the bankruptcy code, home owners like Madsen can often work out a payment plan with the courts to pay pennies on the dollar for their debts. If a debtor sticks to the plan for three to five years, the second mortgage will be forgiven. As many as four million home owners may be able unload second mortgages if they file for bankruptcy. Many of them are completely unaware the option exists. Again, Richard Green.
Green: My guess is it's not widely known at all since until you told me about it, I didn't know about it.
Green says when a second mortgage is eliminated, banks are more inclined to modify the original loan. That could prevent foreclosures and help thousands of people stay in their homes. Bankruptcy lawyer Ike Shulman says he's helped home owners eliminate as much as $7.5 million of second mortgage debt in the past two years.
Shulman: The amount of debt relief that's out there and available to people who need it is enormous.
Leif Madsen and his wife are now two years into bankruptcy. Madsen has a new job. The bank has just finalized a modification on his first mortgage. He's paying $1,800 a month instead of $3,000.
Madsen: I have a lesson that will carry forever. Nut when my children come to this point, when they want to buy houses, the wisdom that we get from this will carry us forward.
As for Madsen and his wife they're not going anywhere. They plan to stay in the house they fought for forever.
I'm Jennifer Collins for Marketplace Money.
Vigeland: There are folks out there who can claim a big "Told ya so!" when it comes to the housing collapse. We've got a post from one of them on our Makin' Money blog.