What's the difference between a lien and collateral? "Collateral" and "lien" are terms that go together, but they're essentially different parts of the same machine. A lien is an interest that a lender has on a piece of property that you give to secure a loan; the property itself is the collateral.
If you're trying to sort through the "lien vs. collateral" question, it's not really a question at all; they're related terms, but they're not the same thing, and they're not opposites. When you borrow money and give the lender a security interest in property, the property itself is the collateral, and the security interest is a lien.
What Is a Lien?
A lien is a right to your property that secures indebtedness. The person or entity to whom you owe money, called the creditor, has the right to take your property and sell it if you don't pay the creditor back. Liens can be both consensual and nonconsensual.
Consensual Liens Vs. Nonconsensual Liens
Consensual liens, which are liens that you give voluntarily so you can borrow money, are quite common. If you borrow money to buy a house or a car, the lender gets a lien on the house or the car. If you take out a business loan, the lender will likely require that you give it a lien on your business assets. You grant the lender a security interest in your property, and it means they have a lien. The lien secures the loan, so that if you don't pay, the lender can take the property. The property you pledge to secure a loan is called collateral.
Nonconsensual liens are liens that occur without your consent. These include judgment liens and mechanics' liens, as well as property tax liens and income tax liens. If you don't pay your debts, judgment creditors, contractors, local governments and the Internal Revenue Service can obtain a security interest in your property by following certain procedures. Like a consensual lien, a nonconsensual lien gives the creditor a right to satisfy your obligation through the property.
Security Interest Vs. Lien: Hand in Hand
The terms "security interest" and "lien" do have subtle differences, but generally, they are used interchangeably. A lien is a type of security interest, and a security interest creates a lien.
Liens are creatures of state law. The laws vary state to state as to how liens are created, perfected and enforced. However, most states follow the same basic rules, even if the procedures are different.
Enforcing a Lien
The purpose of a lien is to allow a creditor to get paid by taking and selling your property. If you default on your mortgage, the mortgage lender can foreclose on the mortgage and eventually sell the house at a sheriff sale. If you don't make your car payments, the lender can repossess the car. If you don't pay your business loans, the lender can take anything you've pledged as collateral and sell it at auction.
A lien is easily created. However, to enforce the lien against others, a creditor must take steps to perfect the lien. A creditor who has a perfected lien can enforce its lien against the property owner and against anyone else who might try to get a lien on the property.
Perfecting a Lien
Lien perfection is a very important part of enforcing a security interest. Perfection gives the world notice that the lien is there. Different types of liens are perfected in different ways.
For example, a lien on business assets is given by signing a security agreement, and the lender must then complete a document called a UCC-1 Financing Statement and record it with the state in which the business is located.
A lien on real estate is perfected when a mortgage document is signed by the property owner, and the document is recorded with the register of deeds where the property is located.
A lien on a motor vehicle in most states is perfected by a notation on the vehicle title.
Types of Liens
The most common types of liens are:
- Mortgages. A mortgage is the type of lien you give to secure a loan with real estate. Your home loan is secured by a mortgage; you can also secure a business loan with a mortgage on real estate.
- Vehicle liens. If you borrow money to buy a car, you give the lender a lien on the car. You can also put up your car as collateral for other loans, if you own the car free and clear. Business loans may be secured by work trucks, for example.
- Liens on business assets. Business loans are hard to get if you don't offer collateral. You can offer up any asset with value as collateral for a business loan, if the bank will accept it.
- Mechanics' liens. Mechanics' liens are liens that a contractor or subcontractor can get on your house or that an auto mechanic can get on your car if you don't pay them for the work they do. These liens are often statutory: the law of your state will provide details about how they can attach. In some states, they're automatic, while in others the contractor has to take steps to attach the lien.
- Property tax liens. Property tax liens arise when you don't pay your property taxes. They attach automatically to your house until paid. If you sell your house, the taxes must be paid before you can pass clear title.
- IRS liens. The IRS can file a tax lien in your state and get a lien on everything you own, including real estate. The IRS will often allow the sale of property without payment in full, because its lien will remain on everything else you own until the taxes are paid.
- Judgment liens. Judgment liens are created in many states when someone sues you and gets a judgment against you. In some states, judgment liens are automatic; in others, the creditor has to take certain actions to get an enforceable lien. In most states, judgment liens attach only to real estate, although in some states, like California, a creditor can attach a judgment lien to personal property.
Mortgages Are Liens on Real Estate
A mortgage is a very common type of lien. To give a consensual lien on real estate, you must execute a mortgage, and to perfect the mortgage, the lender must record the mortgage with the register of deeds for the county in which the real estate is located.
If you don't pay on your mortgage, the lender can initiate the steps to take the property from you and sell it by going through foreclosure.
Car Loans Require a Lien
Financing the purchase of a car will always require that you give the lender a lien on the car. The lender must note its lien on the car's title, and it will remain there until you pay the loan in full and the title is marked paid in full and satisfied. If you don't make your car payments, the lender can repossess the car and sell it, then sue you for the deficiency balance.
Liens for Business Loans
Business loans can be secured by all types of property. To secure a business loan, you must execute a note and security agreement, pledging collateral for the loan. If the collateral is personal property (property that is not real estate), the lender must file a UCC-1 Financing Statement with the state to perfect the interest. If the loan is secured by real estate, you'll need to execute a mortgage. If the loan is secured by a motor vehicle, there will be a notation on the title in addition to a UCC-1.
Lien Priority: Who Gets Paid First?
Often, a piece of collateral will have more than one lien. Real estate commonly has multiple liens: first and second mortgages, property tax liens, IRS liens and judgment liens can all attach to real estate. Business assets may be subject to multiple UCC-1 financing statements from multiple business loans.
If there are multiple liens on one property, the order of payment depends upon lien priority. Perfected liens have priority over unperfected liens, even if the unperfected lien was given first. If multiple perfected liens exist, priority depends upon the type of lien and when each lien was perfected.
With some exceptions (such as property taxes, which must be paid when real estate is sold), the general rule for lien priority in many states is first in time, first in right. Whoever perfects a lien first has first priority, and so on. This comes into play when assets are being sold.
Lien Priority and Real Estate
When it comes to real estate, if the property owner sells the property, all the liens must be paid before he can transfer clear title. If the property goes through foreclosure, however, any money obtained at the sheriff sale gets paid in accordance with lien priority, and some creditors might not get paid at all.
For example, if you buy a house by taking out a mortgage loan, you'll execute a mortgage, which the title company will record with the county, giving the lender a valid, perfected first mortgage. If you then take out a home equity line of credit to rehab your bathroom, you'll give that lender a mortgage, and once recorded, that mortgage goes behind the first. If you don't pay your income taxes and the IRS records a tax lien after the second mortgage is recorded, the tax lien goes behind that. If you get sued and a judgment lien is attached after the tax lien is recorded, the judgment lien goes behind the tax lien, and so on.
If the mortgage company then forecloses, the property taxes will get paid, and the rest will go to the first mortgage company to pay the balance plus the fees from the sheriff sale. The second mortgage, the IRS liens and the judgment liens will only get paid if there is anything leftover.
What if the Collateral Is Underwater?
Occasionally, the collateral for a loan or obligation will have a value that is less than the amount due on the loan. Formally, this means the lender is "undersecured," but in common parlance, you might say the loan is "underwater." If you have an underwater secured debt and the creditor sells the collateral, you still have to pay back whatever the collateral didn't cover.
For instance, if you owe $15,000 on your car when it's repossessed and the lender can only sell it for $10,000, you'll still owe the $5,000 difference. That difference is called the deficiency balance.
Any type of secured debt may lead to a deficiency balance if the collateral isn't worth enough to cover the loan. If a lender agrees to release the lien and allow you to sell the property so it can take what it can get, make sure you have an agreement about whether the lender will pursue the deficiency. If the deficiency isn't waived in writing, the lender might come after you later.