If you’re facing a serious life event such as a job loss, medical problem, or divorce, you might find yourself unable to pay bills and facing foreclosure or the repossession your vehicle. You’ll quickly learn that if you don’t pay a “secured” debt such these, you will lose the property. That’s because when you took out the loan to buy your house or car, you guaranteed repayment of the debt by voluntarily giving the sellers (creditors) a “lien” that allows them to take back the property if you don’t make your monthly payments.
You can also lose property when an involuntary lien—such as for unpaid property taxes or income taxes—attaches to your property. Keep reading to learn about how bankruptcy can help you with your secured debts and liens.
What’s the Difference Between Secured and Unsecured Debt?
When you take out an unsecured debt—for example, when you use a credit card or obtain a personal loan—you promise to pay back the obligation by making monthly payments plus interest. But that’s it. You don’t give your creditor the right to take back any property, called “collateral.” So if you stop paying on your account (default on your payments), your creditor can’t take back the high-speed blender you bought while watching late night television, or the bicycle you gave your son for his birthday. The creditor must file a lawsuit and get a judgment against you before taking steps to collect the debt. Only after obtaining a judgment can the creditor drain your bank account (bank levy) or instruct your employer to take money out of your paycheck (wage garnishment).
But that’s not the case with a secured debt. When you buy large items, like a house or a car, the lender takes additional steps to make sure you’ll repay the loan. The lender insists that you “secure” your payment by promising to give back the property—the collateral—if you default.
For example, when you buy a car, your lender will ask you for the right to repossess the car if you stop making payments, lose your insurance, or do anything else that could jeopardize the value of the car. By agreeing to return the property, you give the lender a“lien” (also called a “security interest”) on the property. The lien remains attached to the property until you pay off your debt.
Security interests serve important purposes: to reassure the lender that it won’t lose money on the deal, and to give notice to other creditors that another lender already has an interest in the property. For instance, after you buy your car on credit, the lien shows up on the state-issued vehicle title. Now, suppose that after purchase, you want to take out a new loan using the same car as collateral. A new lender would quickly see that you already had a lien on the car and either deny the loan or ask that you put up another source of collateral.
The same holds true when you take out a mortgage to purchase a house. The lender will file a copy of the mortgage in the county records office. Again, suppose you apply for a new loan, but instead of pledging your car as collateral, you offer to put up your house. The mortgage will show up when the lender does a search to find out who owns property, and, because the house is already encumbered by a lien, the new lender will likely reject your loan.
Voluntary and Involuntary Liens: How They’re Different
A lien can be either voluntary (you agreed to the lien when you purchased the item) or involuntary (the law gives the lender the right to the lien). Below, you’ll learn how to recognize one from the other.
You must agree to a voluntary lien
You give a lender a voluntary lien when you agree to do one of three things:
- give the lender a lien on new property that you intend to buy
- give the lender a lien on property that you already own, or
- sign a security agreement.
The lien is what gives the lender the right to the collateral. A “security agreement” is the contract that documents the lien on the collateral and sets forth the terms of the lien.
Be on the lookout for a voluntary lien called a “purchase money security interest”
Sometimes you can give a seller a lien without even knowing you did so. For example, when you use credit to buy jewelry or a large appliance, you might give the seller a lien on the goods when you sign the contract. Called a “purchase money security interest,” you’d have to give back your new television, sparkly engagement ring, or even your king size bed if you failed to make your payment. If you’re not sure whether your jewelry, furniture, or appliance store credit card contains a security interest provision, you can check the contract’s fine print or the back of the receipt to find out.
In some cases, the law gives the lender the right to lien your property
State law governs when a lender has a right to place a lien on your property without your permission. Examples of involuntary liens include:
- property tax liens
- income tax liens
- mechanics and materialman’s liens (for labor or materials used in building projects), and
- judgment liens.
To find out more about involuntary liens, see “What Is an Involuntary Lien?”
What Happens to Secured Claims in Bankruptcy?
It’s important to select the bankruptcy chapter that’s right for you—especially when you have a secured debt. Chapter 7 bankruptcy quickly wipes out dischargeable debts, such as credit card balances, medical bills, and personal loans. Chapter 13 bankruptcy allows you to make payments over a three- or five-year repayment plan.
To keep secured property in a Chapter 7 bankruptcy, you must be current on your payments
If you have secured debt and you want to retain the property you’ve pledged as collateral, Chapter 7 bankruptcy works well as long as you meet the following criteria:
- you’re current on your payments, and
- you have enough income to continue making your payments each month.
In Chapter 7 bankruptcy, you’ll tell the court what you want to do with your property when you fill out the Statement of Intention for Individuals Filing Under Chapter 7 form—however, catching up back payments isn’t one of the options. So if you’re behind when you file, you’ll likely lose the property. Here are your choices:
- surrender (give the property back to the lender)
- reaffirm (sign a new contract allowing you to keep the property), or
- redeem (pay what the property is worth in one lump-sum payment).
Some states allow a fourth option, called a “pass-through,” wherein a lender will let you retain the property without signing a new contract as long as you continue making your payments. However, this is not an official option offered on the Statement of Intention for Individuals Filing Under Chapter 7 form. To find out if your local courts will allow for a pass-through, you should consult with a knowledgeable attorney. You can learn more about what happens to secured claims in Chapter 7 bankruptcy by reading “Secured Claims in Chapter 7 Bankruptcy: Can I Keep My House and Car?”
Chapter 13 bankruptcy allows you to catch up on past due payments and keep the property
When you’re behind, Chapter 13 bankruptcy is likely a better choice. You can retain your property and make up your arrearages over the course of your three- to five-year repayment plan.
If you make the mistake of filing for Chapter 7 bankruptcy when you have overdue arrearages, your lender can ask the court to lift the automatic stay—the order that stops creditors from collecting against you once you file for bankruptcy—and, if successful, repossess your home or car. To learn more about secured claims in Chapter 13 bankruptcy, see “Secured Claims in Chapter 13 Bankruptcy: Can I Catch Up on My House or Car Payment?"
Questions for Your Attorney
- Can I give the collateral back to the lender instead of paying the secured claim?
- Will a bank in my local area allow me to make payments on my car without signing a reaffirmation agreement (a pass-through)?
- Do I make enough money to qualify for a Chapter 13 bankruptcy?