Last month, the Supreme Court ruled that homeowners filing for Chapter 7 bankruptcy should not expect a bankruptcy court to cancel a second mortgage on their home, even if their home is severely underwater.
The decision has implications for financially struggling families, but it also serves as a reminder to the dangers of taking out excessive debt on one of your most valuable assets -- your home.
The issue at hand in the court's decision
The case before the justices revolved around homeowners who, in addition to their first lien mortgage, owed money on a second loan also secured by their home.
Specifically, a Florida man owed a first mortgage of $183,264 and a second mortgage of $47,865 to Bank of America (NYSE:BAC). After the real estate collapse, the house was only worth about $98,000. He filed for the protections of Chapter 7 bankruptcy, and asked the courts to cancel the second mortgage as part of the proceedings.
In a Chapter 7 filing, the courts will generally cancel unsecured debts such as credit cards while allowing secured debts to survive the bankruptcy. Attorneys for the borrower argued that because the house was so severely underwater the second mortgage was effectively unsecured. If the Supreme Court agreed, the debt could have been "stripped off," or basically canceled, in the bankruptcy process.
Bank of America's lawyers countered that the loan was secured by the property regardless of the property's value. Considering the value of the house, BofA did not expect to be paid back from its sale; the bank's objective was to maintain the validity of the debt, instead of having it canceled by the court. In that way the borrower would still be required to make payments, eventually repaying the debt.
The Supreme Court ruled unanimously in favor of Bank of America, citing a 1992 ruling that established a secured loan as a debt "supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim."
What does this mean for homeowners?
This ruling effectively maintains the status quo. Second mortgages, including home equity lines of credit, are popular with borrowers, and banks are ready to offer them in large part because of the real estate collateral that comes with the debt.
So for the millions of Americans with second mortgages, including home equity loans, this ruling simply confirms that a Chapter 7 bankruptcy will not cancel out those debts, no matter the value of the property.
This ruling should serve as a reminder of the risks of putting your home on the line as collateral, particularly the added risks of a second mortgage.
The advantages and disadvantages of a second mortgage
Sometimes in life you will need a large amount of cash. It could be for a child's college education, for a major home renovation, or a medical emergency. In those cases, a second mortgage can make sense.
Most people don't have tens of thousands of dollars in a savings account, but many do have that much equity in their home. Instead of borrowers racking up that level of debt in high-interest credit cards, second mortgages can provide the needed cash at a relatively low interest rate and on favorable repayment terms.
In other words, a second mortgage is a smart way to tap into your home's equity when you really need it.
Second mortgages will generally come with a slightly higher interest rate than a first lien mortgage, and they'll also require you to pay a potentially expensive origination fee to the bank. If you're going to pony up for these expenses, you should make sure to put the money to a very good purpose.
On the flip side, a second mortgage should not be used to buy frivolous toys, pay for vacations, or support a lifestyle above your means. These pursuits are a clear path to wealth destruction, which, if taken too far, is only compounded by having a second loan tied to your home. If you fall behind on the payments for either the first or second mortgage you could lose your house to foreclosure.
That's a steep price to pay, and one the Supreme Court thinks is appropriate. Borrower beware.
Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America. The Motley Fool owns shares of Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.