Episode 48: Borrower Bankruptcy

Most note investors don't think about bankruptcy until it happens — but knowing how it affects your lien before you buy a loan with an active filing is what keeps a manageable situation from becoming an expensive surprise. In this episode, we break down what borrower bankruptcy means for your position and what to do about it.

🔍 What you'll learn:

✅ Why the automatic stay stops all collection activity the moment a borrower files — and what you cannot do while it is in effect

✅ How a Chapter 7 discharge eliminates personal liability but leaves your lien on the property intact

✅ Why Chapter 13 is the bigger risk for junior lien holders — and how a lien strip can wipe out a second mortgage entirely

✅ Why only one third of Chapter 13 plans reach discharge — and what a dismissal means for a lien that appeared to be stripped

✅ How to use PACER and Schedule D to research any active bankruptcy and monitor your position through the case

This program is for informational purposes only and should be independently verified before taking action.

Transcript

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Welcome to the show, where you'll learn how to invest in mortgage notes, the savvy real estate investor's secret weapon to create cash flow without tenants and property acquisitions for pennies on the dollar. My name is Robert Haitha, founder of Picknotes, and my mission is to make note investing ethical, profitable, and accessible for you. In every episode, we're democratizing the industry to put these powerful Wall Street assets into the hands of main street investors like you. So without further ado, let's get into this show where you're in good hands with my AI clone. Let's go. This program is for informational purposes only and should be independently verified before taking action. When a borrower files for bankruptcy, it changes the rules of the game. Your ability to collect, to foreclose, and to communicate directly with the borrower is immediately affected. For note investors, bankruptcy is not necessarily a disaster. In many cases, it can actually be a path to resolution. But you need to understand what it means for your position before you buy a loan with an active bankruptcy, and you need to know how to monitor for it in your portfolio. The moment a borrower files for bankruptcy, an automatic stay goes into effect. This is a federal protection that immediately halts all collection activity, all foreclosure proceedings, and all direct contact with the borrower from creditors. As a note investor, you cannot send demand letters, you cannot pursue foreclosure, and you cannot call the borrower to discuss the loan. Everything runs through the bankruptcy court from that point forward. Understanding this is important both for compliance and for managing your expectations on timeline. There are two types of personal bankruptcy that come up most often in note investing. The first is chapter seven, which is a liquidation of debt. The borrower discharges most or all of their personal liability for the debts they owe. The process typically takes three to five months and results in a discharge where the borrower is no longer personally responsible for the mortgage balance. Critically, though, the lien itself survives a Chapter 7 bankruptcy. The debt is discharged, but your security interest in the property remains. If the borrower wants to keep the house, they must continue paying the loan. If they stop paying after discharge, you can still pursue the collateral because your lien is still intact. For second lien holders, the more consequential bankruptcy type is Chapter 13, which is a reorganization of debt. In a Chapter 13, the borrower proposes a three to five year repayment plan approved by the court. During that time, a trustee collects payments from the borrower and distributes them to creditors according to the plan. What makes Chapter 13 particularly significant for junior lien holders is the possibility of a lien strip if a second mortgage is wholly unsecured. Meaning the property value does not cover the first mortgage balance, leaving nothing left over for the second lien. The Chapter 13 plan can strip that second lien entirely. Your lien is removed, your debt becomes uncollectible, and when the bankruptcy is eventually discharged, that loss becomes permanent. However, there is an important caveat to the lien strip that many investors do not fully appreciate. The strip does not become effective until the bankruptcy is discharged, and only about one-third of Chapter 13 plans actually make it all the way to discharge. The remaining two-thirds are dismissed, meaning the borrower failed to complete the plan. When a Chapter 13 is dismissed, any lien strips or cram downs that were pending revert. Your lien comes back. So even if you are looking at a situation where your second lien appears wholly unsecured on paper, the odds are actually in your favor that the bankruptcy will be dismissed before the strip is finalized. When you want to research a bankruptcy, the tool to use is PACER, which stands for public access to court electronic records. It is the federal court's online database and it contains every bankruptcy case ever filed. You search by the borrower's social security number and pull up the case. The most important document to find is the voluntary petition, specifically a section called Schedule D, which lists all secured creditors and the value assigned to the property in each lien. As a junior lien holder, this is where you see whether the borrower is asserting that your lien is wholly unsecured. If the property value shown seems artificially low, your attorney can file a motion disputing that value and arguing for a higher figure that preserves your secured status. Staying on top of active bankruptcies in your portfolio requires consistent monitoring. Most servicers will flag a bankruptcy when it is filed, but following up directly through PACER to track the docket. The running record of all filings in the case is the most reliable way to catch motions for relief, plan amendments, or approaching discharge dates before they catch you off guard. Next time we are going to cover selling the note, when to exit a deal, how to price a non-performing or reperforming loan for resale, and what you can do to maximize what a buyer will pay. Thanks for sticking around to the end, and thank you to my trusty Robot and the Fixed Notes team for putting together another episode. If you want to learn more and hang out with the real not AI version of me, join our free school community at school.com slash fixed notes. That's s ko-o-l dot com slash f I X N O T E S. In the meantime, we'll see you in the next episode.