What Can Creditors Do If You Don't Pay?

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.

What a creditor can and can't do depends on the type of debt and creditor. Debts and creditors fall into different types of legal categories, with some creditors having more rights to collect than others. Because you could be up against some lenders with sophisticated financial knowledge and legal resources, you need to understand the legal status of every one of your debts and what each creditor's rights are.

Secured vs. Unsecured Creditors

The two main categories of creditors are:

• secured creditors (that have rights in secured debts), and
• unsecured creditors (that have rights in unsecured debts).

Secured creditors generally have more rights than unsecured creditors to collect when you don't pay your debt. Typically, to collect a debt, most commercial creditors must first sue you and win a money judgment (a court award) against you. This rule is generally true for unsecured creditors. However, secured creditors can collect the money you owe to them without going through the court system.

Secured Creditors

A "secured creditor" is any creditor to whom you or your business has pledged (given) 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. For example, when your business buys a van, your vehicle might be used as collateral (called "security") for the car loan.

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.

If you don't pay your debt, a secured creditor has three main options available to them to satisfy the unpaid debt:

• repossession
• foreclosure, and
• a court judgment.

We'll discuss these rights later in more detail.

Unsecured Creditors

How Secured Creditors Collect Secured Debts

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 isn't paid.

Repossessions

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 (take) your car. When the creditor repossesses your car, they can sell it to recover the money you owe, plus the costs of the sale and attorney's fees.

The lender doesn't need permission from the court to repossess and sell the car. The lender's authority instead comes from the contract you signed with them when you took out the car loan. (In many states, the lender doesn't have to give you notice of the repossession.)

Even after your car is repossessed, you'll still owe the difference between what the lender sells the car for and what you owe on the loan, called the "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. 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.

Foreclosures

If you have a mortgage or deed of trust on your house, or an open home equity line of credit (HELOC), 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's collateral for your debt. But foreclosures aren't as quick as vehicle repossessions. In some states, a lender has to go to court before foreclosing. In other states, the lender must provide you with notice before foreclosing.

Similarly, if you pledge your house as collateral for a business loan or line of credit and default on that loan, the lender can foreclose on your house. 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 (called "nonjudicial foreclosure").

A judicial foreclosure typically takes several months longer than a nonjudicial foreclosure, giving you time to save some money and, if necessary, find a new place to live.

Avoiding Foreclosure

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
• stretch out your loan over a longer term, or
• convert an adjustable-rate mortgage to a fixed-rate one.

Your other options to avoid foreclosure 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).

For up-to-date information about your options if you're facing foreclosure, see The Foreclosure Survival Guide, by Amy Loftsgordon and Cara O'Neill (Nolo).

How Unsecured Creditors Collect Unsecured Debts

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. A judgment is necessary whether:

• you're 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 limited liability company (LLC), or
• only your corporation or LLC is liable for the debt.

Typically, however, before seriously considering a lawsuit, a creditor will likely try to collect the debt for several months before turning it over to a collection attorney or agency, which will restart the process.

When You Don't Have Assets to Collect

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's no equity in it for creditors to take. Also, suppose 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, might not sue you because they know it's unlikely they could collect the money judgment. With your lack of assets, you're what's called "judgment proof."

Instead, the creditor might 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. (Some states have longer statutes of limitation, up to ten or 15 years.)

When You Do Have Assets to Collect

However, you can expect to be sued if there's significant money at stake and if:

• you have valuable personal or business assets (or just business assets if your business is a corporation or LLC), or
• the creditor expects you to acquire significant assets in the future.

For instance, if you're 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.)

A creditor might think the following assets are 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.

If a creditor does take you to court and wins a judgment against you, it makes sense to pay that court judgment before any other unsecured debts that don't come with a court order. (For more guidance, see our article on prioritizing which business debts to pay.)

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 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.

Garnishing your wages. Probably the most common collection method is for a creditor to obtain a writ of garnishment. The writ allows the sheriff to garnish 25% of your wages to pay the debt. Be aware, however, that some states don't allow wage garnishment. But assuming you're 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, assuming your spouse is named in the court judgment.

Writ of execution. 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 they can find there—in the cash register (called a "till tap") or on your person. Alternatively, a sheriff could be authorized to take business vehicles, equipment, or tools of the trade to pay your debts. However, the sheriff might only take non-cash assets if those items are clearly worth more than you owe on them.

Judgment lien. 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're personally liable for the debt). The lien will allow the creditor to collect the debt when you sell or refinance the property.

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's legally exempt from creditors. Most states provide that a certain amount of your personal assets, such as food, furniture, and clothing, can't be taken by creditors or by the bankruptcy trustee in bankruptcy court. In effect, creditors can't take property essential to your livelihood.

In addition, most states exempt creditors from taking:

• 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 (called the "homestead exemption").

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 by state.

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 our article on spouse and partner liability for jointly-owned business debt.)

Special Rules for Leases

Back rent is treated like any other unsecured debt. However, with unpaid rent, landlords can use 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. An eviction for a commercial property is quicker than a residential eviction—it can be over in just a few weeks.

Try negotiating with the landlord to let you make up unpaid rent over the next several months. Start negotiations before the landlord files an eviction lawsuit. Your landlord might be more willing to negotiate if:

• a lot of properties are vacant in your area
• you can show that, while your business is short on cash, you have a believable long-term survival plan, or
• you can 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 business costs.

If you have to move out with time remaining on a lease—residential or commercial—your landlord can sue you for the remaining months' rent. However, in most states, the landlord must try to re-rent the space to minimize the loss (called "mitigating the damages.") To limit your liability, you can also help your landlord find a new tenant.

For tips on getting out of a lease early, see our article on how to break a commercial lease when you go out of business.

Getting Help With Business Debts

If you've been sued or 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 our section on small business bankruptcy.

You can also negotiate with creditors to limit your debts. Typically, only unsecured creditors will be willing to negotiate, especially if they think you'll just get rid of the debt in bankruptcy and they'll never see a dime. For tips, see our article about strategies for negotiating with creditors.

If you decide to shut your business's doors, see our section on going out of business, for information on how to minimize your personal liability while closing your business.

If your debt is piling up and creditors are starting to make moves, it's best to meet with a local business attorney as soon as possible. Involving a lawyer early in the process can help you negotiate better deals with creditors, evaluate your options for dealing with the debt, and limit your liability.