What Is a Perfected Lien?

When you finance a purchase, such as a car or house, your loan documents usually contain a promissory note and a security agreement. The promissory note contains your promise to make the specified payments. The security agreement gives your lender a security interest in whatever you’re financing (the collateral). This security interest is called a lien. A lien allows your lender to legally take the collateral from you if you don’t make your payments as agreed. 

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 as collateral for a loan. Some examples of this type of lien include a title loan or a home equity line of credit. 

When you finance a purchase or pledge something as collateral, you voluntarily give the creditor a lien against the collateral. But some types of liens can attach to your property without your consent. For example, if someone sues you and gets a judgment against you, the judgment can become a lien against your house or other property. Certain types of debt, such as unpaid taxes, can automatically become a lien against all your property as a matter of law.

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

How Does a Creditor Perfect a Lien?

The steps required to perfect a lien depend on your state laws and the type of lien in question. For example, when you finance real estate, your lender typically files a mortgage or deed of trust in your local land records. When your loan is paid in full, your lender files another document in the local land records saying that the lien is paid, or “released.” 

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

Why Is it Important To Perfect a Lien?

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

• Protects the lienholder by serving as evidence for their right to take or keep the collateral and by preventing the debtor from selling the collateral to someone else without first paying the lien. 

• Protects potential purchasers from unknowingly buying property subject to liens.

• Protects potential lenders from unknowingly accepting collateral that is already subject to other liens.

• Protects the debtor by requiring a secured party to have public evidence of their right to take or keep collateral. A perfected auto lien, for example, is the difference between repossession and car theft. 

Requiring secured creditors to perfect their liens also establishes a clear lien priority. This makes it easier to determine the rights of buyers, creditors, and other parties, especially if there are conflicting security interests.

What Does ‘Lien Priority’ Mean?

Sometimes, there may be more than one lien attached to the same collateral. This is most common with houses and other real property. For example, say you take out a mortgage to buy a house. A few years later, you don’t pay your taxes, and the IRS files a tax lien against you. A few years after that, someone sues you and gets a judgment lien against you. 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 against the house. 

Your state’s lien priority laws determine the order in which these liens get paid if there’s a foreclosure. In most states, the general rule is “first to file.” This means the creditor that perfected, or filed, their lien first gets paid first. The creditor with the security interest perfected second gets paid second, etc. In the example above, the IRS and the judgment creditor may not get paid in full, or they may not get paid at all. 

How Do Perfected Liens Affect My Bankruptcy?

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

To determine whether an asset is exempt, first, calculate how much equity you have in the asset. Your equity in an asset is the asset’s value minus the amount of any debt you owe on it. For example, if 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 — not the asset’s full value. So, in the example above, you would only need to use $4,000 of your available exemptions to fully protect your car.

What if My Creditor Never Perfected Their Lien?

Perfecting a lien has many benefits for both borrowers and lenders, and most creditors perfect their liens right away in their ordinary course of business. But sometimes, a creditor fails to perfect their lien correctly. This is most likely to happen if the creditor is a friend or family member. Unlike a commercial lender, friends and family members aren’t always aware of the lien perfection requirements or the necessary steps for perfection of a lien.

If you owe money on your car or another asset but your creditor never perfected their lien, then their lien may not stand in a Chapter 7 bankruptcy. Under Section 544 of the Bankruptcy Code, the bankruptcy trustee’s liquidation rights take priority over any lien that isn’t properly perfected. In other words, if your creditor didn’t perfect their security interest before you filed bankruptcy, the trustee can file an adversary proceeding to avoid, or eliminate, the unperfected lien. The higher the asset’s liquidation value, the more likely a trustee might be to pursue this course. 

To understand the consequences of avoiding the lien, consider the example from the previous section: Your car is worth $14,000 and you owe $10,000, so 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 from the car’s value. This means you now have $14,000 equity in the car. Unless you have $14,000 of available exemptions, the trustee will likely sell your car. (For reference, the federal motor vehicle exemption is currently limited to $4,450.) 

In addition, if the trustee avoids the lien, then the creditor who loaned you the money also loses their lien on the car. The loan will become an unsecured debt and may be wiped out by your bankruptcy discharge.

Let’s Summarize…

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

The Bankruptcy Code gives bankruptcy trustees power to set aside any lien that isn’t properly perfected. Setting a lien aside increases the odds that an asset will be liquidated by the trustee. A lien is more likely to be unperfected if the creditor is a friend or family member rather than a commercial lender. If you have these types of loans, ensure that the creditor has perfected their lien before you file bankruptcy.