Even though bankruptcy wipes out your personal obligation to repay a secured debt, the creditor’s lien on your property survives your Chapter 7 bankruptcy case (unless the property is returned to the creditor).
What Is a Lien?
A lien is created when a creditor or someone else has a security interest in your property. Liens comes part and parcel with secured debts. A debt is secured if it is linked to a specific item of property, called collateral, which guarantees payment of the debt. If you don’t make payments when they are due, the creditor can repossess the collateral. The creditor’s legal claim on the collateral is called a lien.
Liens can be created when you agree to put up collateral for payment of the debt (for example, your mortgage). They also can be created without your consent (for example, the IRS records a lien against your property for nonpayment of a tax debt).
What Happens to Liens in Chapter 7 Bankruptcy?
A secured debt consists of two parts, and each part is treated differently in Chapter 7 bankruptcy.
- Your personal liability for the debt, which obligates you to pay back the creditor. Bankruptcy wipes out your personal liability for the debt, assuming the debt qualifies for the bankruptcy discharge. This means the creditor cannot later sue you to collect the debt.
- The creditor’s legal claim (lien or security interest) on the collateral for the debt. A lien gives the creditor the right to repossess the property or force its sale if you do not pay the debt. If the collateral is unavailable, the lender can sue you for the value of the collateral. A lien sticks with the property even if you give the property to someone else. Bankruptcy, by itself, does not eliminate liens. However, during bankruptcy, you may be able to take additional steps to eliminate, or at least reduce, liens on collateral for security interests. (To learn more, see Avoiding Liens in Bankruptcy.)
Because liens survive Chapter 7 bankruptcy, if you stop making payments on a secured debt after bankruptcy, the lender can repossess the collateral. The lender, however, cannot sue you for a deficiency (the difference between what you owe and the value of the collateral) because your personal obligation for the debt is gone (assuming the debt was discharged).
Example. Mary buys a couch on credit from a furniture store. She signs a contract agreeing to pay for the couch over the next year. The contract also states that the creditor (the store) has a security interest in the couch and can repossess it if any payment is more than 15 days late. In this type of secured debt, Mary’s obligation to pay the debt is her personal liability, and the store’s right to repossess the couch is the lien. Bankruptcy eliminates her obligation to pay for the couch, but the creditor retains its lien and can repossess the couch if she doesn’t pay.
Lenders Must Perfect Their Liens
For bankruptcy purposes, security interest agreements qualify as secured debts only if they have been perfected: recorded with the appropriate local or state records office. For instance, to create a lien on real estate, the mortgage holder (the bank or another lender) must typically record it with the recorder’s office for the county where the real estate is located. To perfect security interests in cars or business assets, the holder of the security interest must typically record it with whatever statewide or local agency handles recordings under the Uniform Commercial Code (these are called “UCC recordings,” and they are usually filed with the secretary of state or department of state).