What Can Creditors Do If You Don't Pay?
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First, know that you can't be thrown in jail for not paying your debts (with the exception of back child support, if you could pay but don't). And a creditor can't just take money from your bank account or grab your tax refund—unless you owe back taxes or you've defaulted on a student loan. To collect a debt, the general rule is that most commercial creditors must first sue you and win a money judgment (a court award) against you.
But, there is a big exception to this rule: Creditors don't have to sue first if the debt is guaranteed by collateral. Common examples are a car loan where the car you bought is security (collateral) for the loan, or a mortgage or home equity loan where the house itself is pledged as collateral (though in about half of the states, a lender has to go to court before foreclosing).
Because you may be up against some lenders with sophisticated financial knowledge and legal resources, it's important for you to understand the legal status of each and every one of your debts and what each creditor's rights are.
Debts and creditors fall into different types of legal categories, meaning that some of your creditors have more rights to collect and a bigger ability to negatively affect you and your business than do others. The two main categories of debts and creditors are secured and unsecured.
Secured vs. Unsecured Creditors
A secured creditor is any creditor to whom you or your business has pledged collateral in exchange for a loan, line of credit, or purchase. Collateral might be business property, such as inventory and equipment, or your own property, such as your house, car, or boat.
There are also "involuntary secured creditors"—those who have filed a lien (legal claim) against your property because they have a judgment against you or you owe a tax debt.
Either way, if you or the business can't pay back the debt, a secured creditor can repossess or foreclose on the secured property, or order it to be sold, to satisfy the debt.
An unsecured creditor is one to whom no collateral has been pledged and who hasn't filed a lien. Typically, unsecured debts include credit card charges and amounts your business owes for inventory, office supplies, furnishings, rent, and advertising, as well as what's owed for services such as maintenance, equipment repair, or professional advice.
Many businesses owe secured debts—businesses typically pledge collateral for credit lines, and business owners often pledge their personal property for business debts. Let's take a look at how quickly lenders can call in or foreclose on collateral when a secured debt is not paid.
As you probably know, if you miss a payment or two on your car loan (and, as is typical, the loan was used to buy the car and is secured by the car), the lender has the legal right to physically repossess the car and sell it to recover the money you owe, plus the costs of the sale and attorney's fees. To do this, the lender doesn't have to get permission or a court judgment. Under the terms of the contract you signed with the lender, a repo man can simply reclaim the lender's property. (In many states, the lender doesn't have to give you notice of the repossession; you will just wake up and find your car gone.) When all is said and done, you will still owe the difference between what the lender sells the car for and what you owed on the loan, called a "deficiency." Also, the repossession will appear on your credit report for seven years.
Cars are the most commonly repossessed type of property, but if you borrowed money to buy business equipment or machines and used the purchased equipment as security, the creditor will have the same repossession rights. Also, some department store credit cards provide that the creditor automatically takes a security interest in the property you buy, so if you don't pay the bill, the creditor might try to repossess the property. However, because creditors must get a court order to enter your house or business, repossession of property other than vehicles is rare.
Similarly, with leased vehicles or business equipment, if you miss a lease payment, the leased property can usually be immediately reclaimed without a court order.
If you have a mortgage or deed of trust on your house, or an open home equity line of credit, you must make payments on time to keep the house. If you don't, the lender can and probably will foreclose on your house, because it is collateral for your debt. But foreclosures are not as quick as vehicle repossessions. In half of the states a lender has to go to court before foreclosing, and in the other half, advance notice is required from the lender.
Similarly, if you pledge your house as collateral for a business loan or line of credit and you default on that loan, the lender can foreclose on your house. (In this situation, the lender must always file a foreclosure action in court, no matter what state you're in.) To avoid having the lender foreclose, you must either repay the debt or, if the debt is more than your equity in the house, at least pay the lender that amount so that it no longer has a reason to foreclose.
The foreclosure process works differently in different states. In some states, the lender must file a lawsuit to foreclose on a house (called judicial foreclosure). In others, it can foreclose on property without going to court (nonjudicial foreclosure). A judicial foreclosure typically takes several months longer than a nonjudicial foreclosure (though in California a nonjudicial foreclosure can take a year or more), giving you time to save some money and, if necessary, find a new place to live.
If you're behind on your mortgage, you might be able to negotiate a loan modification with your lender. For example, the lender might agree to add your missed payments to your loan balance, to stretch out your loan over a longer term, or to convert an adjustable rate mortgage to a fixed-rate one. Your other options are selling your home for less than you owe (called a short sale), returning the deed to the lender (called a deed in lieu of foreclosure), or refinancing through the Federal Housing Administration (FHA) or the Homeowner Affordability and Stability Plan. For up-to-date information about your options if you are facing foreclosure, see The Foreclosure Survival Guide, by Stephen Elias (Nolo).
Filing for bankruptcy can delay foreclosure. When you file for bankruptcy, all creditors, including mortgage lenders, must cease collection activities and foreclosures. However, the lender can ask the bankruptcy court for permission to proceed with a foreclosure if you're behind on your payments, so a bankruptcy may delay a foreclosure only a couple of months. (For more on bankruptcy in general, see Nolo's Bankruptcy Center.)
Unsecured creditors such as credit card companies and most trade creditors must first sue you and win a money judgment against you before they grab your income and property. This is true whether you are personally liable for the debt (as is the case for sole proprietors and partners, or because you signed a personal guarantee for your corporation or LLC) or whether only your corporation or LLC is liable for the debt. (Learn whether you're personally liable to pay your business's debts.)
Typically, however, before seriously considering a lawsuit, a creditor will try to collect the debt for several months and then turn it over to a collection attorney or agency, which will restart the process. In some instances, the creditor will conclude that you don't have enough property that can easily be grabbed to pay off the judgment, and won't bother suing.
For instance, say your house is worth less than you owe on your mortgage, meaning that there is no equity in it for creditors to take. Also suppose that your consignment shop has few business assets and is doing so poorly that you don't anticipate having more than a few dollars of steady income that a creditor could grab (by ordering the sheriff or marshal to take money from the business premises). Your creditors, or any collection attorney or agency your debt is turned over to, may not sue you because they know it's unlikely they could collect the money judgment. That's called being "judgment proof."
Instead, the creditor may simply write off your debt and treat it as a deductible business loss for income tax purposes. Typically, in five or six years, depending on your state's statute of limitations, the debt will become legally uncollectible. (Only a few states, such as Kentucky, Louisiana, Ohio, and Rhode Island, have longer statutes of limitation, up to ten or 15 years.)
However, you can expect to be sued if there is significant money at stake and you have valuable personal or business assets (or just business assets, if your business is a corporation or LLC)—or if the creditor expects you to acquire significant assets in the future. For instance, if you are a sole proprietor and have an advanced degree, your creditor might assume you'll eventually make a decent salary and will sue you now—and just wait for you to make some income. (In many states, a court judgment can be collected for at least ten years.)
What does a creditor think is worth suing for? Significant amounts of cash or accounts receivable, valuable business equipment and property, and, if you're personally liable for a debt, valuable personal assets such as jewelry, fine art, collectibles, antiques, motorcycles, expensive bicycles, boats, or a vacation house.
Don't try to hide assets. Sometimes, out of desperation, a business owner tries to protect personal or business assets by giving them to friends and relatives or otherwise trying to hide them from creditors. Although few small business people have the knowledge necessary to move cash to an offshore bank account, many try to hide it in the name of a parent, child, coworker, or friend. Don't do this. Creditors' attorneys are experienced in ferreting out such hidden assets, and in extreme cases, these tactics can even give rise to civil and criminal charges of fraud.
If a creditor does take you to court and wins a judgment against you, it obviously makes sense to pay the court judgment before any other unsecured debts that you haven't yet been sued over. (See Nolo's article on Prioritizing Which Business Debts to Pay First.)
How a Creditor Must Collect a Judgment
Collecting a judgment is harder than winning it. If a creditor has gone to court and won a judgment against you for collection of an unsecured debt, theoretically the creditor (now called a judgment creditor) will be able to take any cash in your business's bank account, your business income, and your business assets to pay off the debt. If you're a sole proprietor or partner, or you signed a personal guarantee for a debt, the judgment creditor could also garnish your wages and take money from your personal bank account, as well as take your nonexempt personal property, to pay off the debt. However, to take money or property, the creditor must first locate it and then get a court order and pay the sheriff to take it.
Probably the most common collection method is for a creditor to obtain a writ of garnishment, under which a sheriff could garnish 25% of your wages to pay the debt (except in Pennsylvania, South Carolina, and Texas, where garnishments are not allowed). But assuming you are a self-employed business owner without a side job, garnishing your wages will be pretty difficult since you don't get a paycheck (unless you're an employee of your corporation). However, your spouse's wages could be garnished to pay your business debts if you live in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, or Wisconsin), assuming your spouse is named in the court judgment.
Often a more effective collection technique (if your business sells goods or services for cash) is for the sheriff to come to your business and take any money he can find there—in the cash register (called a "till tap") or on your person. Or a sheriff could be authorized to take business vehicles, equipment, or tools of the trade to pay your debts, something that will happen only if those items are clearly worth more than you owe on them. It's also possible that the creditor could get a court to order your bigger customers and clients to pay any money they owe you directly to the court.
However, most creditors won't go to these lengths to get your property. Instead, many will simply attach a "judgment lien" to any real estate or assets the business owns (or valuable personal property or real estate that you own, if you are personally liable for the debt). The lien will allow the creditor to collect the debt when you sell or refinance the property.
Check to see if any liens are recorded against your business. The Secretary of State's office in every state maintains a registry of liens, listing judgment liens, tax liens, or security interests that creditors claim in your property. You can do a Uniform Commercial Code (UCC) records search online at your Secretary of State's website to search for your personal and business names to see what liens have been recorded against you. If you find any incorrect information—say you have paid off a debt but it hasn't been reflected—ask the lender in question for a UCC release, something that is required by law.
About Wage Garnishment
If you do have regular wages coming in, perhaps from a side job or because you are an employee of your corporation, your wages can be garnished to enforce a court judgment. The total amount your creditors can take from your wages is 25% of your net pay. That limit applies whether you have one creditor or many. And if your wages are low, there are additional protections—you must be left with weekly income equal to 30 times the federal hourly minimum wage. (A few states have lower limits.) But if you owe back child support or back taxes and your wages are being garnished, expect to lose a much larger percentage of your wages—50% or more, depending on whether you are supporting others. Social Security checks, retirement plan proceeds, unemployment and disability benefits, or workers' compensation awards cannot be garnished, except to pay federal taxes or child support (or unless they have accumulated in your bank account).
Exempt Property—What a Judgment Creditor Can't Take
Although a judgment creditor can usually grab cash from your bank account or force the sale of most business assets, a judgment creditor can't take personal property that is legally exempt from creditors. Most states provide that a certain amount of your personal assets, such as food, furniture, and clothing, cannot be taken by creditors or by the bankruptcy trustee in bankruptcy court. In addition, most states exempt from creditors:
- the equity you own in one vehicle, up to a certain amount—commonly from $1,000 to $5,000, and
- a significant amount of the equity in your house—often between $10,000 and $50,000, depending on the state.
Find your state's exemptions. To find out how much your state exempts for your vehicle and house, and a complete list of exempt property, see our section on bankruptcy exemptions.
Most states also let you keep a couple of thousand dollars' worth of business equipment and tools of the trade, as well as money in tax-deferred retirement plans. Also, in most states (except community property states, discussed above), a creditor can't take property that belongs to you and your spouse if the debt is in your name only. (For more information, see Spouse and Partner Liability for Jointly Owned Debt.) The practical effect of these exemptions is that, no matter how many debts you have and no matter how many judgments are entered against you, creditors can't grab much essential property.
EXAMPLE: For years, Dax's hobby has been restoring classic cars; he owns two himself, a '64 Shelby Cobra and a '59 Cadillac Eldorado. After being urged by his friends to quit his day job to do what he loves, Dax opens his own shop that offers custom auto detailing, paintless dent repair, auto painting, and classic car restoration. He applies for a business license, rents a small warehouse in an industrial area, buys two auto lifts, and increases his cache of tools, which was already sizable. To pay for everything, he takes a personal equity line of credit out on his house, after striking out in his attempts to get a bank line of credit for the business. Unfortunately, almost as soon as Dax opens his doors, the economy declines, and people cut back on luxury services such as regular car detailing, and even dent and ding repair. At the same time, many classic car enthusiasts are forced to put their hobbies on hold. As a result, Dax doesn't bring in enough money to cover his costs, can't pay his rent, and goes out of business, leaving a mountain of debts.
If he is sued or has to file for bankruptcy, here is what he has to lose and what he should be able to hold on to:
Since Dax lives in California, is married, and has only $60,000 equity in his house (he owes $300,000 and the house is worth $360,000), he will get to keep his house (California law exempts $75,000 of equity for families). He will also get to hold on to his clothing, furnishings, and appliances. He will be able keep only $2,550 in equity in personal vehicles, so he is likely to lose his classic cars. He will also be able to keep up to $6,750 in business assets, if he has fully paid for them and if he continues to use them to make a living, including tools, equipment, and a commercial vehicle. Unfortunately, the rest of his business assets will likely be taken. He also stands to lose the money in his business bank account, as well as his personal bank account, because he was a sole proprietor. If he gets a new job, up to 25% of his wages could also be garnished. And if Dax's wife brings home an income, 25% of that income can be garnished to pay the business's debts, if his wife is listed in the judgment. (If Dax files for bankruptcy, however, the wage garnishments will stop.) Fortunately, Dax's IRA is safe from creditors.
Bankruptcy can get rid of unsecured debts. If you have been sued or have been threatened with a lawsuit, you're at risk of losing cash or property. If the majority of your debt is unsecured and you have little chance of paying it off, you might consider bankruptcy, which can get rid of most, if not all, of your unsecured debt. For more information on bankruptcy and alternatives, see Nolo's overview of bankruptcy for small businesses. Also, if you decide to shut your business's doors, see Nolo's section on Going Out of Business, for information on how to minimize your personal liability while closing your business.
Special Rules for Leases
Back rent is treated like any other unsecured debt, but you are subject to streamlined eviction procedures if you don't pay. If you're behind on residential rent payments, the landlord is likely to start an eviction lawsuit against you within a few weeks. Unless the building is found to be uninhabitable (substandard or unsafe), chances are you'll be ordered to vacate within about six weeks. A commercial eviction is quicker than a residential eviction—it can be over in just a few weeks.
You can try to negotiate with the landlord to make up unpaid rent over the next several months, but do this before the landlord files an eviction lawsuit. Your landlord may be likely to negotiate if lots of properties are vacant in your area. If you can show that, while your business is short on cash, you have a believable long-term survival plan, you may be able to get a new lease with lower rent. Your chances will improve if you can possibly show that you or a private lender will invest new capital in the business if the lease and other obligations are reduced. (For more on negotiating your rent down, see our article on ways to cut costs.)
If you have to move out when you have time remaining on a lease—residential or commercial—your landlord can sue you for the remaining months' rent. However, in most states the landlord is obligated to try to rerent the space first to minimize the loss. This is called "mitigating the damages." For more information, see Nolo's article on how to get out of a lease early, with the fewest consequences.
Find a new tenant yourself. A landlord who expects to eventually collect from you all of the rent you owe under the broken lease may move slowly to find a new tenant. If you help find a new tenant and get the space filled faster, you'll limit your future liability under the lease.