The Problem with Home Equity Lines of Credit (HELOCs)

During the housing bubble here in the Bay Area, and particularly, in San Jose, California, home values rose at eye-popping appreciation rates for most of the 2000s. Until 2008, many of our bankruptcy clients saw their homes’ values skyrocket. During that time, banks and mortgage brokers aggressively peddled non-purchase money second mortgages in the form of Home Equity Lines of Credit or HELOCs. These were loans that were not used to finance the purchase of the home. Instead, they were taken out later, after the purchase, as the equity in the property rose as the overall housing price bubble grew. HELOCs are very often a ticking time bomb for our bankruptcy clients.

Our San Jose Bankruptcy Attorneys’ Perspective on HELOCs

As consumer debtor bankruptcy lawyers, our view of HELOCs, and the reckless lending from which so many of today’s HELOCs resulted, may be somewhat unique. Indeed, we can say from broad experience that Home Equity Lines of Credit have necessitated a significant portion of the Chapter 7 and Chapter 13 bankruptcies we have filed in the last 2-3 years. Why? Because California’s Anti-Deficiency Rules (the laws the prevent some home mortgage lenders from suing the homeowner AFTER a foreclosure) do not apply to any HELOC that was not used to purchase the property. While first lenders on California deeds of trust cannot sue for a deficiency judgment (roughly, the amount by which the home was underwater at the time of the foreclosure sale, increased by trustee sale administration fees, bank attorney fees, etc.) after they foreclose through the typical non-judicial foreclosure, holders of many second loans can sue.

The California anti-deficiency rule on second loans (those who do not elect the remedy of foreclosure in the first place) requires that the loan must have been a purchase-money loan in order to get protection from a deficiency judgment after foreclosure.

Hence, in our San Jose, CA, bankruptcy practice, we have represented many clients who have already suffered a foreclosure on their home or rental, who nevertheless now are faced with a lawsuit by the bank that held their HELOC. Even though that property is now gone. Even though they will now never enjoy the kitchen remodel that the HELOC had financed.

In a typical scenario, a few months after the foreclosure, the bank holding the HELOC suddenly sues the former homeowner and obtains a judgment against him or her. Now the former homeowner has judgment debt of perhaps $150,000 with nothing to show for it. The bank can now garnish the former homeowner’s wages, empty his or her bank accounts, and record liens against any other property owned by the debtor.

Obviously, this situation in nearly all cases makes bankruptcy inevitable. No one is prepared to have their wages garnished for years to come to pay debt on a Home Equity Line taken on a home lost to foreclosure.

The good news is that in Chapter 7 bankruptcy, provided the debtor qualifies for Chapter 7 relief, a HELOC on a foreclosed home is dischargeable to the same extent as any other unsecured, dischargeable debt. Even if the debtor can only qualify for a Chapter 13 bankruptcy, as long as the debtor’s income and expenses allow, the HELOC will typically only receive a small percentage of the balance owed, and can be discharged after only 3-5 years of such fractional payments. Better yet, if a Chapter 13 debtor’s home is now worth less than the outstanding principle balance owed on the debtor’s first mortgage, then the HELOC second mortgage may be stripped from the property and treated as unsecured debt. If that Chapter 13 debtor finishes his or her Chapter 13 payment plan, he or she can emerge from bankruptcy, owning the home free and clear of the HELOC mortgage.

New California Law Protects Homeowners from HELOCs after a Short Sale

On July 15, 2011, California Governor Jerry Brown signed into law SB 458 which provides anti-deficiency protections to California home owners from HELOCs after a short sale (but not after a foreclosure). While we welcome this new protections, as we have written elsewhere, we worry that second lienholders may attempt to circumvent SB 458 by either refusing to approve the short sale, or by attempting to get the seller to sign a new unsecured promissory note as a condition of approval. Such tactics do not appear to be expressly forbidden in SB 458, so only time will tell to see whether California courts will prohibit such extortion by HELOC lenders going forward. The best protection from a HELOC is, of course, bankruptcy — either a Chapter 13 lien strip where the homeowner can emerge from bankruptcy owning the property free and clear of the HELOC’s lien, or if the owner cannot feasibly complete a Chapter 13, then through a discharge of all personal liability for the HELOC through a Chapter 7. In the latter scenario, although the second lien will remain against the property, at least the HELOC lender will never be able to sue the homeowner personally should the home eventually be foreclosed upon.

To see if a Chapter 13 lien strip is possible in your situation, or to discuss whether Chapter 7 can discharge personal liability on your Home Equity Line of Credit, and to schedule a free consultation with a San Jose bankruptcy attorney at the Law Offices of Jon Brooks in San Jose, CA, please call us at 408.286.2766. Prior to our appointment, we ask that you download our Personal Bankruptcy Questionnaire, fill it out to the best of your ability, and bring this information with you to your meeting with us.

We are proud to be a Debt Relief Agency as defined by federal law. We help people get out of debt by filing for relief under the Bankruptcy Code.

By Jon G. Brooks