What Is a Perfected Lien and How Does It Affect Bankruptcy?

A lien against your car or home shows that the lender has a security interest. A perfected lien is one that has been properly recorded by the lienholder. Once a lien is perfected, the lienholder can enforce their legal right to the property. You need to understand perfected liens if you have secured debt when filing bankruptcy.

Understanding Liens and Security Interests

When you finance a purchase, your loan documents contain a promissory note and security agreement. The promissory note contains your promise to make specified payments. The security agreement gives your lender a security interest in whatever you’re financing. Security interests allow your lender to legally take the collateral from you.

Mortgages and car loans are among the most common types of consumer liens. But you don’t have to be buying the collateral for a lien to arise. A lien can also occur when you pledge something you already own. Examples include title loans or home equity lines of credit.

When you finance a purchase, you voluntarily give the creditor a lien against the collateral. But some types of liens can attach to your property without your consent. If someone sues you and gets a judgment against you, the judgment becomes a lien. Certain types of debt, such as unpaid taxes, automatically become liens by law.

For a lien to be valid and legally enforceable, the creditor must file documentation. The creditor files a financing statement in a government office or publicly accessible database. A lien that is properly recorded is called a perfected lien. A few types of liens don’t require filing to be perfected. A mechanic’s lien, for instance, is perfected if the mechanic has your car.

How Does a Creditor Perfect a Lien?

The steps required to perfect a lien depend on your state laws. They also depend on the type of lien in question.

When you finance real estate, your lender typically files a mortgage or deed. They file it in your local land records. When your loan is paid in full, your lender files another document. The document states that the lien is released.

For a motor vehicle lien to be perfected, the lienholder must be noted. The lienholder appears on the car’s title, and the title must be registered. The lender notifies the state when the loan is paid in full. In some states, the lender has physical possession of the certificate. This helps prevent the car’s owner from selling it without paying the loan.

Why Is It Important To Perfect a Lien?

Registering a lien puts the public on notice. Notice is the most important reason for perfecting a lien. Establishing a perfected security interest:

• Protects the lienholder by serving as evidence for their rights
• Prevents the debtor from selling the collateral without paying the lien
• Protects potential purchasers from unknowingly buying property subject to liens
• Protects potential lenders from unknowingly accepting collateral already subject to other liens
• Protects the debtor by requiring public evidence of the creditor’s rights

A perfected auto lien is the difference between repossession and car theft. Requiring secured creditors to perfect their liens also establishes clear lien priority. Priority makes it easier to determine the rights of buyers and creditors.

What Does Lien Priority Mean?

Sometimes, more than one lien attaches to the same collateral. Multiple liens are most common with houses and other real property.

Say you take out a mortgage to buy a house. A few years later, you don’t pay your taxes. The IRS files a tax lien against you. A few years after that, someone sues you and gets a judgment. Eventually, you can’t afford the house payments, and the mortgage company forecloses. The mortgage company, the IRS, and the judgment creditor all have perfected liens.

Your state’s lien priority laws determine the order in which liens get paid. In most states, the general rule is “first to file.” The creditor that perfected their lien first gets paid first. The creditor with the second security interest gets paid second. In the example above, the IRS and judgment creditor may not get paid.

How Do Perfected Liens Affect Your Bankruptcy?

In a Chapter 7 bankruptcy, the bankruptcy trustee can liquidate your assets. The trustee sells your assets and divides the money among your creditors. Exemption laws allow you to protect some or all of your property. Most Chapter 7 debtors can claim all their assets as exempt.

To determine whether an asset is exempt, calculate your equity first. Your equity in an asset is its value minus any debt you owe. Say your car is worth $14,000 and you owe $10,000. You have $4,000 equity in the car. The exemptions only need to cover the amount of your equity. You would only need to use $4,000 of available exemptions to protect your car.

What If Your Creditor Never Perfected Their Lien?

Most creditors perfect their liens right away in their ordinary course of business. But sometimes, a creditor fails to perfect their lien correctly. Improper perfection is most likely with friend or family member creditors. Unlike commercial lenders, friends and family aren’t always aware of perfection requirements.

If you owe money on your car but your creditor never perfected their lien, their lien may not stand. The Bankruptcy Code outlines the bankruptcy trustee’s liquidation rights take priority. If your creditor didn’t perfect their security interest before you filed, the trustee can avoid the lien. The trustee files an adversary proceeding to eliminate the unperfected lien.

Consider the consequences of avoiding the lien. Your car is worth $14,000 and you owe $10,000. You have $4,000 equity in the car. You only need $4,000 of available exemptions to protect your car.

If the trustee avoids the lien, you can’t subtract the $10,000 loan balance. You now have $14,000 equity in the car. Unless you have $14,000 of available exemptions, the trustee will likely sell it. The federal motor vehicle exemption is currently limited to $4,450.

If the trustee avoids the lien, the creditor who loaned you money loses their lien. The loan will become an unsecured debt. Your bankruptcy discharge may wipe it out completely. If you’re considering bankruptcy and have loans from family or friends, speak with a bankruptcy attorney for free to understand your options.

Key Points About Perfected Liens

If you finance a purchase or pledge property as collateral, the lender has a lien. Certain types of debt can also give rise to liens. Generally, a lien is perfected when it is recorded in appropriate government records. The steps necessary to perfect a lien vary by state and lien type.

The Bankruptcy Code gives trustees power to set aside improperly perfected liens. Setting a lien aside increases the odds of asset liquidation by the trustee. A lien is more likely to be unperfected if the creditor is a friend. If you have these types of loans, ensure the creditor perfected their lien. Do this before you file bankruptcy.