What Happens to Liens in Chapter 7 Bankruptcy?

Bankruptcy works well to wipe out many types of debt. However, if a lender has a lien attached to the obligation—meaning that the creditor can take certain property if the borrower fails to pay—things can get tricky.

In most cases, a creditor's lien survives Chapter 7 bankruptcy. When the lien remains, the creditor can take the property after the bankruptcy case closes if the filer doesn't pay as agreed.

What Is a Lien?

No one wants to lose money—including lenders—and the risk of loss is especially great when the loan involves a big purchase like a house or car. Lenders minimize this risk by requiring the borrower to agree that if the debt isn't paid as promised, the creditor will be able to take the collateralized property. This agreement gives the creditor an ownership interest in the property called a "lien."

A lender who recovers property will usually sell it at auction and use the proceeds to pay toward the outstanding loan balance. In most cases, if the auction price is less than what's owed, the borrower will remain responsible for the outstanding balance, known as a "deficiency balance."

Keep in mind that some states prohibit deficiency balances on certain transactions. Also, Chapter 7 bankruptcy will wipe out a deficiency balance—more below.

Liens Create "Secured Debt" in Chapter 7 Bankruptcy

If you've started preparing your bankruptcy paperwork, you'll have noticed that you must categorize your debts as either secured or unsecured. A debt with a lien on it? It's secured. No lien? It's unsecured.

Here are more details about these important terms:

• Secured and unsecured debt. When a creditor has a lien guaranteeing payment of a loan, the obligation is called a "secured" debt. By contrast, an unsecured debt, such as a credit card balance, is one in which the borrower isn't required to guarantee payment by putting up property.
• Collateral. The property guaranteeing a debt is called collateral. The creditor's lien interest in the collateral exists until the borrower pays off the debt. It's the lien that gives the creditor the right to repossess or foreclose on the collateral if you don't make payments when due.

Find out more about classifying secured, unsecured, and priority debt in Chapter 7 bankruptcy.

Voluntary and Involuntary Liens in Chapter 7 Bankruptcy

If the lien is voluntary, you agreed to it, and if it's involuntary, someone placed the lien on your property without your permission. Why does this matter? Because you might not realize you have a lien on your property and that a creditor has a secured debt.

Voluntary Liens

It's common to agree to give a creditor a lien as part of your mortgage or car note transaction. Because you agreed to those terms when you financed the property, you likely know that you could lose your home to foreclosure or your car to repossession because of the creditor's lien.

But many people don't realize they agree to a lien when purchasing jewelry, furniture, electronics, mattresses, equipment, and computers on credit. Check your contract or receipt.

Involuntary Statutory Liens

Some creditors have the legal right to put a lien on your property without your consent, and it's not unusual to have a lien against your property without knowing about it.

For instance, the Internal Revenue Service (IRS) might record a lien against your property for nonpayment of tax debt. Your homeowners' association might put a lien on your house if you don't pay your dues. Or, a contractor might place a lien on your home if you fail to pay for repairs.

Involuntary Judgment Liens

Some creditors turn an unsecured debt into secured debt by suing the borrower in court and using the money judgment to place a lien on your property. You'll find more about the process in the "Credit Card Debt and Judicial Liens" section.

Learn more about the different types of property liens, including voluntary and involuntary liens.

Judicial Liens: Credit Card Balances, Medical Bills, and Other Unsecured Debt

Many people file for Chapter 7 bankruptcy after an unsecured creditor gets a judicial lien and becomes a secured creditor.

A creditor creates a "judicial" or "judgment" lien by suing a borrower in court, winning, and getting a "money judgment" against the borrower for the amount owed, plus fees and costs. A creditor with a money judgment can record it against the borrower's real estate.

In some states, the money judgment automatically gives the creditor a lien on the borrower's personal property, which is all property other than real estate.

How an Unsecured Creditor Gets a Money Judgment

The process starts when the borrower fails to pay a bill for unsecured debt, such as a credit card balance or unpaid rent. Because you don't give the creditor collateral to secure these debts, the creditor can't force payment without winning in court.

A creditor who believes the amount owed is large enough to justify the cost of litigation will file a civil lawsuit. If the borrower doesn't respond, the court will issue a "default" money judgment, and the creditor will automatically win.

The court will also issue a money judgment if the borrower loses after filing an answer to the lawsuit's complaint. Learn about lawsuits stopped by filing for bankruptcy.

How the Creditor Turns a Money Judgment Into a Lien

A creditor who wins a money judgment becomes a "judgment creditor" and must "perfect" or create an enforceable lien. Usually, perfecting the lien occurs after recording the money judgment at the recorder's office or following other state law provisions.

Benefits of Perfecting a Lien

Once perfected, if the borrower sells real estate in the recorder's jurisdiction (usually the county), the lien will get paid out of the sales proceeds. The title company handling the transaction determines whether any recorded liens exist and pays them before dispersing funds to the home seller.

Judicial liens can also encumber personal property. But most people can protect their household possessions and cars with exemptions, so these items are rarely pursued. Most states let people protect property from creditors using the same exemptions available in bankruptcy.

Other Ways Creditors Use Money Judgments

A judgment creditor can use a money judgment for more than lien creation. Most use money judgments to withdraw money from the borrower's bank account (bank levy) or deduct funds from the borrower's paycheck (wage garnishment).

Learn more in Collecting From a Judgment Debtor: Wage Garnishment, Property Liens, and Bank Account Levies.

What Happens to Liens in Chapter 7 Bankruptcy?

This area can be tough to grasp, but it can be summed up like this:

• Chapter 7 bankruptcy will likely wipe out your responsibility to pay a secured debt, such as a mortgage or car payment.
• Chapter 7 bankruptcy won't wipe out a voluntary lien, so the creditor can still take the collateral (the house, car, or other property) unless you pay what you owe.

However, you can ask the court to set aside a judgment lien when it prevents you from getting the benefit of an exemption. For instance, if an exemption entitled you to keep $15,000 of property equity encumbered by a judgment lien, you can ask the court to set aside the lien up to $15,000.

Learn about keeping your home in Your Home in Chapter 7 Bankruptcy and your vehicle in Options to Keep Your Car in Chapter 7 Bankruptcy.

Why Chapter 7 Doesn't Automatically Eliminate Liens

Because filing for bankruptcy removes your responsibility to pay, after Chapter 7, a creditor can't collect a debt erased by your discharge. However, Chapter 7 doesn't change your obligation to return property when a lien is in place and you don't pay as agreed.

So even though the creditor can't force you to pay what you owe, the creditor can take back the property if you don't pay voluntarily. This result occurs because a secured transaction has two primary parts:

• Your obligation to pay back the creditor. It's your responsibility to pay the entire debt. Bankruptcy wipes out your personal liability for the debt, assuming that it qualifies for the bankruptcy discharge. This means the creditor cannot later sue you to collect the debt and use the judicial lien (see above) to garnish your wages or take money out of your bank account.
• The creditor's right to use the lien to recover the collateral. It's your creditor's right to offset any amount you owe by selling the collateral securing the debt. The lien allows the creditor to repossess the property and force its sale if you don't 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 a lien.

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.

During bankruptcy, you might 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.

Lenders Must Perfect Their Liens

For bankruptcy purposes, a security interest agreement qualifies as a secured debt only if the creditor perfects it by recording the lien 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 exists.

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 (called "UCC recordings")—usually with the secretary of state.

Find out more about UCC recordings in How to Attach and Perfect a Security Interest Under the UCC.

Why File for Chapter 7 Bankruptcy?

So why might filing for Chapter 7 bankruptcy be better than letting the house or car go through foreclosure or repossession? The answer is that it wipes out your obligation to pay the entire loan, including a deficiency balance.

Also, sometimes, it might prevent a tax obligation from being assessed because forgiven debt gets taxed as income. For instance, if you let your house go through foreclosure and the lender forgives the deficiency balance, you could receive a hefty tax bill at the end of the year.

You can learn more about this type of tax liability by reading Tax Consequences When a Creditor Writes Off or Settles a Debt.

Meet With a Bankruptcy Lawyer

Sometimes it makes sense to file for Chapter 13 rather than Chapter 7 when you're dealing with a lien, and you don't want to risk losing your home, car, or other collateral—especially if you're behind on the payment when you file. A local bankruptcy lawyer will review your case and help you formulate a strategy to protect your property.

Need More Bankruptcy Help?

Did you know Nolo has been making the law easy for over fifty years? It's true—and we want to make sure you find what you need. Below you'll find more articles explaining how bankruptcy works. And don't forget that our bankruptcy homepage is the best place to start if you have other questions!

We wholeheartedly encourage research and learning, but online articles can't address all bankruptcy issues or the facts of your case. The best way to protect your assets in bankruptcy is by hiring a local bankruptcy lawyer.