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.
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.
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:
Find out more about classifying secured, unsecured, and priority debt 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.
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.
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.
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.
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.
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.
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.
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.
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.
This area can be tough to grasp, but it can be summed up like this:
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.
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:
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.
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.
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.
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.
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!
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