Second mortgages introduce a major wrinkle into the bankruptcy process. Since they are secured loans, the lenders who issue them are entitled to a claim on the underlying piece of real property. This can bring second-mortgage lenders into direct conflict with primary mortgage lenders.
In theory, both primary and secondary mortgage lenders can be satisfied by the bankruptcy process. Borrowers typically take out a second mortgage when they're struggling to keep up with their current portfolio of debt obligations. These credit products are often used to pay down part of a primary mortgage or to zero out the balances of existing high-interest unsecured debts. Although both loans are secured by the underlying piece of property, second mortgages are subordinate to primary mortgages.
A home is said to be "underwater" when its value decreases until it's worth less than the balance that remains on the primary mortgage. Even though it won't be able to recoup its losses in full, an underwater home's primary mortgage lender may still seize the home to cover a portion of its investment. By contrast, the subordinate second lender has no physical claim to the property. Since it stands little chance of recovering a significant portion of the investment, it may "charge off" the loan. It will appear in the lender's financial records as a total loss.
Unfortunately, the lender's decision to charge off the loan doesn't alter its status as a secured creditor of the bankrupt party. While it can't physically seize the underlying property unless the primary mortgage lender chooses not to, the second mortgage lender still retains a lien on the property. In theory, this entitles it to compensation by other means. If you're confronted by a second-mortgage lender that refuses to release the lien on your underwater home, you have two distinct options.
Since your second mortgage is a secured obligation, it won't be discharged in bankruptcy. As such, you won't escape from the bankruptcy process without compensating your second mortgage lender in some form. You may wish to continue making regular payments on your loan until your bankruptcy proceedings conclude. Secured lenders rarely initiate legal action against bankrupt borrowers who continue to make timely payments.
If you still owe a great deal on your second mortgage, you may wish to pursue a settlement with your lender. In some circumstances, it may be willing to accept just 50 percent of your outstanding balance.