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 so the creditor will still have the ability to take the property securing the debt after the bankruptcy case closes if the loan remains unpaid.

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 purchased property (or other agreed property), sell it at auction, and use the proceeds to pay down the outstanding loan balance. This agreement gives the creditor an ownership interest in the property called a "lien."

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 types of transactions. Also, Chapter 7 bankruptcy will wipe out a deficiency balance—more below.)

Here are some other important terms you should know:

• 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.

Although it's common to agree to give a creditor a lien (for instance, as part of your mortgage or car note transaction), some liens are created without your consent by operation of law. For instance, the Internal Revenue Service (IRS) might record a lien against your property for nonpayment of tax debt. Liens on unsecured debt come into being after the creditor sues the borrower in court (more in Credit Card Debt and Judicial Liens below).

Credit Card Debt and Judicial Liens

All liens don't come about the same way. A creditor creates a judicial lien (also called a "judgment" lien) after suing the borrower in court and getting a money judgment against the borrower. The creditor then records the judgment against the borrower's real estate. (Usually, the money judgment gives the creditor a lien in the borrower's personal property automatically.)

The process starts when the borrower fails to pay a bill for an unsecured debt, such as a credit card balance or utility bill. Because collateral doesn't secure these types of debts, the creditor can't force payment without doing more—until the creditor sues and wins in court, that is.

If the creditor believes the amount owed is large enough to justify the cost of litigation, the creditor will file a civil lawsuit. If the borrower doesn't respond, the court will issue a "default" judgment, and the creditor will automatically win. If the borrower responds (answers), yet loses after defending the case, the court will issue a judgment, as well.

Next, the creditor must "perfect" the lien (complete the steps necessary to create an enforceable lien) by recording the judgment at the recorder's office, or by following other provisions outlined in state law. 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 off) before dispersing funds to the home seller.

Judicial liens can encumber personal property (everything other than real estate). Most people can protect their household possessions and cars with exemptions, so these types of items are rarely pursued. Instead, a creditor is more likely to use the judgment to withdraw money out of 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 Levys.)

What Happens to Liens in Chapter 7 Bankruptcy?

This area can be tough to grasp. So here's a quick way to sum this up: Chapter 7 bankruptcy will likely wipe out your responsibility to pay a secured debt (such as a mortgage or car payment), including any deficiency balance; however, you won't get to keep the collateral (the house, car, or other property) unless you pay what you owe.

(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.)

Here's how this works:

A secured transaction has two primary parts: a responsibility and a right.

• 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 gives the creditor the ability 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 just 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, in some cases, 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.