A creditor is a “secured” if it has the right to take a borrower’s property to satisfy the borrower’s debt. By contrast, an unsecured creditor—such as a credit card or utility company—is limited to calling or sending letters asking for payment.
In bankruptcy, if the Chapter 7 bankruptcy trustee—the official tasked with managing the case—sells property securing a debt, the secured creditor will get paid before any unsecured creditors. Similarly, in a Chapter 13 case, an unsecured creditor will receive funds only if money remains after paying secured claims.
Typically, secured creditors include mortgage companies and car lenders. In both transactions, the borrower voluntarily agrees to guarantee the loan by giving the lender an interest (lien) in the property purchased (collateral) with the loan proceeds.
For instance, when taking out a home loan, the borrower gives the lender a lien by agreeing to put up the house as collateral. If the homeowner falls behind on the payment, the bank can initiate a foreclosure proceeding, sell the home at auction, and use the proceeds to pay down the loan.
A car buyer gives a lender similar lien rights when financing a vehicle. If the borrower doesn’t pay as agreed, the creditor can repossess the car, sell it at auction, and apply the money toward the loan balance.
Not all liens are voluntary. If you fail to pay your income taxes, the federal government can take steps to obtain a lien against your assets without your consent (involuntary lien). An unsecured creditor can do the same by filing a lawsuit and winning a judgment for the amount you owe.
While most voluntary liens are limited to particular property, such as a home, car, or boat, an involuntary lien can extend to all of a debtor’s assets. For example, a few of the things that a judgment creditor can do include:
A lien gives a secured creditor the right to get paid before other creditors—including in bankruptcy. If the trustee sells encumbered property (property with a lien on it) in a Chapter 7 case, the trustee must pay the secured creditor before paying other creditors. If the property has multiple liens, the trustee will pay each lien according to the “first in time” rule (the earliest lien gets paid first).
Example. Josh financed a $20,000 sailboat with the Big Boat Company. As part of the contract, he agreed to give Big Boat a lien on the sailboat. Three years later, Josh filed for Chapter 7 bankruptcy. His debt totaled $120,000, $5,000 of which he still owed to Big Boat. The trustee sold the sailboat for $15,000. Because Big Boat had a lien against the boat, the trustee paid Big Boat the balance of $5,000 and distributed the remaining $10,000 (minus trustee fees) to the other creditors.
In a Chapter 13 case, the filer must have sufficient income to pay all monthly secured payments, such as a house or car payment. If any funds remain, the trustee will distribute them to the unsecured creditors.
Example. Jessie filed a Chapter 13 case to stop a foreclosure sale. She was required to make a monthly payment of $2,500 for five years. Out of the monthly payment, the trustee paid $2,100 to the mortgage company (the monthly payment plus a portion of the mortgage arrearages) and a $300 car payment. The trustee divided the remaining $200 between Jessie’s unsecured creditors—three credit cards, an overdue electric bill, and an unpaid gym contract.