Section 506(a) of the Bankruptcy Code separates the debtor’s obligations into two general categories or “claims”: secured claims and unsecured claims. Secured claims are obligations in which payment is guaranteed (or “backed” or “secured” or “collateralized”) by property. Section 506(a)(1) provides that a secured creditor’s claim is “a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property . . . and is an unsecured claim to the extent that the value of such creditor’s interest . . . is less than the amount of such allowed claim.” Consequently, when the value of the property is less than the amount of the secured claim, Section 506(a) allows the obligation to be divided into a secured claim and an unsecured claim.
For instance, suppose the debtor finances a car for $40,000. It’s commonly said that a car depreciates the minute it drives off the lot, so let’s say the car is now worth $35,000 and no payment has been made. In bankruptcy, this car loan would have a secured claim of $35,000 (the value of the collateral) and an unsecured claim of $5,000.
The most notable prohibition against reducing the amount owed on a secured obligation is found in Section 1322(b). This provision, often called the “anti-modification provision,” prohibits a Chapter 13 debtor from modifying the rights of a secured claim when the claim is secured only by the debtor’s principal residence. The U.S. Supreme Court in the case of Nobelman v. American Savings Bank, 508 U.S. 324 (1993), decided that 1322(b) means that a claim against the debtor’s primary residence cannot be bifurcated into secured and unsecured claims. However, most bankruptcy courts have distinguished the ruling in Nobleman to allow a junior mortgage to be stripped away if the value of the senior claims are more than the value of the debtor’s home.
To understand how lien stripping works, consider the following “negative equity” example of a debtor’s home:
Value of home: $330,000
First mortgage: $360,000
Second mortgage: $40,000
Amount of equity -$70,000
Most courts allow the $40,000 second mortgage to be stripped off and reclassified as an unsecured debt because the amount owed on the first mortgage is more than the value of the home. In other words, the second mortgage is not actually secured by anything because the amount owed on the first mortgage “eats up” all of the home’s equity. There is no equity left to secure the second mortgage. If the second mortgage was partially secured, even by one dollar, the second mortgage could not be lien stripped according to Nobelman.