In bankruptcy, your personal obligation to pay a secured debt may be discharged, but the lien remains in place.
A creditor’s lien typically endures Chapter 7 bankruptcy. If the debtor doesn’t make the agreed-upon payments while the lien is active, the creditor may seize the property once the bankruptcy process is over.
How Do Liens Work?
Nobody hates to lose money, not even lenders, and when a loan is required to make a large purchase like a house or car, the danger of loss is greater still. By forcing the borrower to acknowledge that the creditor may seize the collateralized property if the debt is not paid as agreed, lenders reduce this risk. This contract grants the creditor a “lien,” or ownership stake in the property.
When a lender recovers property, they often auction it off and apply the money to the outstanding loan sum. In most situations, the borrower will still be liable for the remaining sum, or “deficiency balance,” if the auction price is less than what is owing.
Remember that in some states, shortfall balances on particular transactions are not permitted. A deficit balance will also be eliminated in Chapter 7 bankruptcy; see more below.
“Secured Debt” is created via Liens in Chapter 7 Bankruptcy
You must classify your debts as either secured or unsecured if you have already begun putting together your bankruptcy petition. A loan with a charge against it? It is locked. No liens? It’s unprotected.
Chapter 7 Bankruptcy: Voluntary and Involuntary Liens
If the lien is voluntary, it was put on your property with your consent; if it is involuntary, it was done so against your will. Why is this important? because you might be unaware that a creditor has a secured debt against you and that you have a lien on your property.
In the course of a mortgage or vehicle note transaction, it’s typical to consent to granting a lien to a creditor. You are probably aware that the creditor’s lien could cause you to lose your home to foreclosure or your car to repossession because you agreed to those terms when you financed the property.
But when buying items like jewelry, furniture, electronics, beds, equipment, and computers on credit, many people are unaware that they are agreeing to a lien. Check your agreement or invoice.
Statutory Liens Without Consent
It’s common to have liens placed against your property without being aware of them because certain creditors have the legal authority to do so without your knowledge.
For instance, if you don’t pay your tax due, the Internal Revenue Service (IRS) may place a lien on your property. If you don’t pay your dues, your homeowners’ association may place a lien on your home. Or, if you don’t pay for repairs, a contractor could put a lien on your house.
Liens for Involuntary Judgments
By filing a lawsuit against the borrower and utilizing the money judgment to put a lien on your property, some creditors can convert an unsecured debt into a secured debt.
Medical bills, credit card balances, and other unsecured debt are all considered judicial liens.
After an unsecured creditor obtains a judicial lien and transforms into a secured creditor, many people apply for Chapter 7 bankruptcy.
By filing a lawsuit against a borrower, succeeding, and obtaining a “money judgment” against the borrower for the amount owing plus fees and costs, a creditor can establish a “judicial” or “judgment” lien. A money judgment holder may register it against the borrower’s real estate.
Any property owned by the borrower that is not real estate is considered personal property, and in some states, the money judgment immediately grants the creditor a lien on that property.
How to Obtain a Money Judgment as an Unsecured Creditor
The procedure begins when the debtor is unable to make a payment on an unsecured obligation, like an outstanding credit card amount or overdue rent. You do not provide the creditor with collateral to secure these debts, thus the creditor cannot compel payment absent a judicial ruling.
A creditor will initiate a civil lawsuit if they feel that the debt is significant enough to warrant the expense of legal action. The court will issue a “default” money judgment and the creditor will be declared the winner if the borrower doesn’t reply.
If the borrower loses after submitting an answer to the complaint in the litigation, the court will also issue a money judgment. read about litigation that bankruptcy averted.
How a Money Judgment Becomes a Lien in the Mind of the Creditor
After receiving a monetary judgment, a creditor is deemed a “judgment creditor” and is required to “perfect” or establish an enforceable lien. Perfecting the lien often happens after the money judgment has been recorded at the recorder’s office or after adhering to other state legal requirements.
Advantages of a Perfected Lien
Once perfected, the lien will be paid out of the sale proceeds if the borrower sells real estate within the recorder’s authority (often the county). Before distributing money to the house seller, the title firm managing the transaction examines whether any recorded liens exist and pays them.
Personal property may also be encumbered by judicial liens. However, the majority of people have exemptions that allow them to defend their vehicles and home goods, therefore these targets are rarely used. Most states allow persons to use the same exemptions that are available in bankruptcy to safeguard property from creditors.
Use of Money Judgments by Creditors in Other Ways
A money judgment can be used by a judgment creditor for purposes other than creating liens. Most take use of money judgements to take money from the borrower’s bank account (bank levy) or take money out of their paycheck (wage garnishment).
How Are Liens Affected by Chapter 7 Bankruptcy?
This topic can be challenging to understand, but it can be summed up as follows:
Your need to pay a secured debt, such as a mortgage or car payment, will probably be eliminated if you file for Chapter 7 bankruptcy.
If you don’t pay what you owe, the creditor can still seize the collateral (the house, car, or other property) because Chapter 7 bankruptcy won’t remove a voluntary lien.
When a judgment lien prohibits you from benefiting from an exemption, you can seek the court to set it aside. For instance, you may seek the court to remove the lien on up to $15,000 of your property equity if an exemption allowed you to keep the remaining $15,000 of equity.
Why Liens Are Not Automatically Eliminated by Chapter 7
After Chapter 7, a creditor cannot pursue you for a debt that has been discharged by your bankruptcy since filing for bankruptcy releases you from the obligation to pay. When a lien is in place and you don’t make the agreed-upon payments, Chapter 7 does not affect your obligation to return the property.
Therefore, even if the creditor cannot physically force you to pay your debt, if you refuse to do so voluntarily, the creditor may seize your property. This outcome results from the fact that a secured transaction includes two main components:
Your duty to reimburse the creditor. You are liable for paying the total debt. In the event that the debt is eligible for the bankruptcy discharge, filing for bankruptcy will discharge your personal duty for it. This implies that the creditor is prevented from subsequently filing a lawsuit against you to recover the debt and from using the judicial lien (discussed above) to garnish your earnings or deduct funds from your bank account.
The ability of the creditor to reclaim the collateral through the lien. Your creditor has the right to use the proceeds from the sale of the collateral used to secure the loan to offset any amounts you owe. If you don’t pay the loan, the lien enables the creditor to seize the property and force its sale. The lender has the right to sue you for the value of the collateral if it isn’t available. Even if you transfer ownership of the property to another party, a lien remains on it. A lien is not removed by bankruptcy on its own.
Example. Mary purchases a couch from a furniture retailer using credit. She agrees to pay for the couch over the following year by signing a contract. According to the contract, the couch has a security interest in favor of the creditor (the store), who has the right to reclaim it if any payment is more than 15 days overdue. In a secured debt of this kind, the lien is the store’s right to take back the couch, and Mary’s responsibility to pay the loan is her personal liability. She is no longer obligated to pay for the couch after filing for bankruptcy, but the creditor still has a lien on it and has the right to take it back if she doesn’t.
You might be able to take extra actions during bankruptcy to get rid of or at least lessen liens on collateral for security interests. See Avoiding Liens in Bankruptcy for further information.
Lenders Must Make Their Liens Perfect
A security interest agreement only counts as a secured debt for bankruptcy purposes if the creditor reports the lien with the proper municipal or state records office to “perfect” the lien. In order to establish a lien on real estate, for instance, the mortgage holder (the bank or another lender) normally needs to record the lien with the county’s recorder’s office.
The holder of a security interest must typically record it with the state or municipal agency that handles UCC recordings (also known as “UCC recordings”) in order to perfect a security interest in a vehicle or commercial asset. Typically, this is the secretary of state.
Why File for Bankruptcy Under Chapter 7?
Why then may declaring Chapter 7 bankruptcy be preferable than allowing the property or automobile to go through a foreclosure or repossession? It eliminates your need to repay the full loan, including any outstanding shortfall sum, is the solution.
Due to the fact that forgiven debt is treated as income, it may also occasionally preclude the assessment of a tax liability. For instance, if you permit the foreclosure of your home and the lender forgives the unpaid sum, you can be hit with a big tax payment at the end of the year.
In Chapter 7 bankruptcy, secured debts are handled differently than other debt types.
The majority of people have a loan that is backed by real estate, like a mortgage or a car loan. In Chapter 7 bankruptcy, these obligations, often known as secured debts, can be challenging. Even while the secured debt itself can be eliminated (discharged) and frequently is, the creditor will still retain the power to repossess the property if you fall behind on your payments (default).Your options in Chapter 7 bankruptcy will depend on whether you’re current on your loan payments and whether you wish to maintain any collateral for the loan, such as a house or a car.
A Secured Debt: What Is It?
Almost always, if you’re making payments on a piece of property, you’ve agreed that the asset will be used as security for the debt’s repayment. If you stop making payments, the creditor (or lender) may seize the home, sell it, and file a lawsuit against you (a deficiency judgment) to recover the difference between what you owe and what the home sells for at the auction (however, some states have laws against deficiency judgments).
A secured loan includes two components:
Personal responsibility Just like with any other obligation, you are personally liable for secured debt. You have a duty to make the required payment to the creditor. If this personal liability falls among the categories of debt that bankruptcy allows for discharge, Chapter 7 bankruptcy eliminates it. The creditor cannot file a lawsuit against you to recoup the debt once your personal liability has ended.
Chapter 7 bankruptcy options
If you qualify for Chapter 7 bankruptcy, you can do the following with property used to secure debts:
Let the bank receive the property back. By giving up the property and paying off the underlying loan, you can go with no further obligation. All filers have access to this choice.
Keep the house and keep paying the mortgage. As long as your payments are up to date and you have an exemption in place to safeguard your equity, you may continue to be bound by the terms of your contract. The debt is reaffirmed throughout this procedure.
Pay the property’s fair market value. If you can safeguard your equity with an exemption and the property satisfies other restrictions (for example, you cannot redeem real estate), you may keep the property by redeeming it (paying what it is worth in one lump sum payment).
Can You Exempt (Keep) The Equity In Your Property?
When you declare bankruptcy, you can protect some assets, but there are restrictions. The exemptions that your state permits will also determine whether you are eligible to maintain a certain asset. The bankruptcy trustee appointed to your case will sell the asset for the benefit of your creditors if you are unable to preserve all of the equity.
Example. Consider the scenario where you owe $3,000 on a car that is worth $6,000 and have $3,000 in equity, and your state’s vehicle exemption will allow you to save $1,000. Most likely, you wouldn’t be permitted to keep the vehicle. Instead, the trustee would sell it, give you your $1,000 exemption in cash, pay your secured creditor the remaining $3,000 you still owe on it, and then divide the remaining $2,000 (minus the costs of selling and the trustee’s compensation) among creditors.
Even still, borrowers of secured loans frequently owe more than the asset used to secure the loan is worth, which implies that they have no equity in the asset. The trustee won’t be able to sell the property if you don’t own any equity in it or if it is entirely protected by an exemption. By redeeming the item or reaffirming the debt, you might keep the asset.
What Is a Chapter 7 Bankruptcy Reaffirmation?
When you reaffirm a debt, you agree that you will still owe it after your bankruptcy case ends. Both the creditor’s lien on the collateral (which gives the creditor the right to take the property if you fail to pay as agreed) and your liability to pay the debt will survive bankruptcy intact.
In most cases, it will be as if you never filed for bankruptcy for that debt.
Advantages to Reaffirmation in Chapter 7
Reaffirmation provides a sure way to keep collateral as long as you abide by the terms of the reaffirmation agreement and keep up your payments. If you stay current on the payment, the lender won’t be able to take back the property.
Reaffirmation also provides an opportunity to negotiate new terms to reduce your payments, your interest rate, or the total amount you will have to pay over time. However, the lender doesn’t have to agree to new terms and most reaffirmation agreements are on the original contract terms.
How Reaffirmation Affects Your Chapter 7 Bankruptcy
Because reaffirmation leaves you personally liable for the debt, you can’t walk away from the debt after bankruptcy. You’ll still be legally bound to pay the deficiency balance even if the property is damaged or destroyed. And because you have to wait eight years before filing another Chapter 7 bankruptcy case, you’ll be stuck with that debt for a long time.
For instance, if you reaffirm your car note and then default on your payments after bankruptcy, the creditor can (and probably will) repossess the car, auction it off, and bill you for the difference between what you owe and what the trustee received at auction.
Example 1. Suppose you owe $25,000 on your car before filing for Chapter 7 bankruptcy. You most likely will continue to owe $25,000 on your car after you file for bankruptcy (unless you negotiate a lower amount in your reaffirmation agreement). If you can’t keep up your payments and the car is repossessed, you’ll owe the difference between the $25,000 reaffirmation amount and the amount the lender sells the car for at auction, or “deficiency balance,” which will be considerably less than you owe, in most cases). Nearly all states permit a creditor to sue for a deficiency balance. However, about half of the states don’t allow deficiency balances on repossessed personal property if the original purchase price was less than a few thousand dollars.
Example 2. Tasha owes $1,500 on a computer worth $900 and reaffirms the debt for the full $1,500. Two months after bankruptcy, she spills a soft drink ruining the computer. Because she reaffirmed the obligation, she still must pay the creditor the remaining balance.
Restrictions on Reaffirmation
The first step is ensuring the Chapter 7 bankruptcy trustee won’t sell your property. If you can’t protect all of the equity with a bankruptcy exemption, the trustee will sell it, pay the lender, give you the exemption amount, and use the remaining proceeds to pay unsecured creditors.
However, if you can protect all of the property equity, you can use a reaffirmation agreement and continue paying on “secured” property that’s encumbered by a lien. You and the creditor must agree to any change in terms.
Also, you or the lender must file the agreement in court as part of the bankruptcy case. The bankruptcy court must review the agreement in a reaffirmation hearing if an attorney does not represent you. If you have a lawyer, the lawyer must sign the agreement and attest that you can afford the payment and that it won’t cause undue financial hardship.
At the hearing, the judge will consider how the reaffirmation might affect your post-bankruptcy budget and whether you can afford the payments. The judge can reject the agreement if it isn’t in your best interest or would create an undue hardship for you or your family.
Reaffirmation agreement rejections occur when it appears that you can’t afford the payments after paying your basic living expenses or if you owe much more on the debt than the property is worth. The bankruptcy judge will make this determination after reviewing the income and expense forms filed with the bankruptcy petition in your case.
When to Enter Into a Reaffirmation Agreement
Sometimes a lender will let you keep a car or other property without filing a reaffirmation agreement as long as you continue making your payment. This is a good way to go because if the lender repossesses the property because you can’t make your payments, or you let the car go back to the lender after an accident, you won’t be responsible for paying anything further.
That won’t be the case if you enter into a reaffirmation agreement. Because reaffirming a debt comes with the disadvantage of leaving you in debt after your bankruptcy case ends, you should consider it only if:
- the creditor insists on it
- it’s the only way to keep property you need, and
- you have good reason to believe you’ll be able to pay off the balance.
Reaffirmation might be the only practical way to keep some property types, such as automobiles or your home. Also, reaffirmation can be a sensible way to keep property that is worth significantly more than what you owe on it.
If you decide to reaffirm a debt, it’s usually worth asking the creditor to accept less than you owe as full payment. For most people, it’s not a good idea to reaffirm a debt for more than what it would cost you to replace the property.
Keep Current on Payments You Wish to Reaffirm
If you need the collateral, you’ll want to be current on your payments before filing for bankruptcy to stay on the creditor’s good side. If you fall behind, the creditor can demand that you bring your account current before agreeing to a reaffirmation contract.
Differences Between Collateral and Secured Debt
It’s common to wonder how secured and unsecured debts differ. The answer is simpler than you might think.
When applying for a credit account or taking out a loan, the lender might ask you to put up collateral (valuable property) that it can sell if you fail to pay your bill—especially when borrowing a large sum of money. The collateral assures or guarantees the lender that it will get paid if you stop making your payment as agreed.
Securing a loan with collateral creates a “lien” on the property, a type of ownership interest that remains until the borrower pays off the debt. The lien interest gives a creditor the right to repossess your vehicle if you fail to make your payment. Likewise, if you fall behind on your mortgage, the lien will allow the lender to foreclose on your home.
A bank or creditor who owns a collateralized debt has what is called a “secured debt.” If the bank seeks reimbursement in a bankruptcy case, it will file a “secured claim.” If the bankruptcy trustee sells the property, the trustee must pay the secured lender first before distributing funds to unsecured creditors.
However, not all creditors require a borrower to provide security when making a loan or providing a credit service. An “unsecured” creditor doesn’t have a lien interest in collateral, so it can’t sell the borrower’s property to pay off the debt without doing more.
Credit cards, medical bills, and personal loans, such as payday loans are all examples of unsecured debt. An unsecured creditor can gain a security interest by winning a debt collection lawsuit and recording the money judgment with the local recorder’s office or the appropriate state agency.