If you take out a small business loan and the lender requires collateral, they may place a lien on your assets. Here's what you should know about liens.
- A lien is a legal filing that gives a lender the right to your property or assets if you fail to repay a loan.
- You can get rid of a lien by paying off your debt or filing for bankruptcy.
- Liens can be placed on property, equipment, vehicles, jewelry, furniture and other personal assets.
- This article is for entrepreneurs who want to know about one of the risks they could face when taking out a loan.
Lending money is risky, which is why lenders often protect their investments with liens, which are legal filings that allow them to claim a piece of property if the borrower defaults on repayment. If the lender has secured the loan through a lien, you can't meet your monthly payments, and the lender has tried to settle the debt, they can usually sell the assets you've put up as collateral to cover their loss.
Liens can also be placed on loans when they're initially taken out, because a lien acts as the vehicle for securing business assets to cover a loan.
What is a lien, and how does it work?
A lien gives a lender a legal claim or right to property or assets you own because you owe them money. Lenders keep this claim until you pay down your debt.
"Liens secure a financial obligation," said Stuart Wolfe, a lawyer who represents banks with the firm Wolfe & Wyman. "A lien can't exist without an obligation. If you pay off the financial obligation on a traditional mortgage on your house, the mortgage or deal of trust goes away because it has nothing to secure."
Liens can be placed on real estate, equipment or pretty much any other type of valuable personal property.
"'Personal property' might sound like it refers to real estate, but it is a legal term that refers to equipment, vehicles, jewelry, furniture and any other things a person can own," said Jane Muir, an attorney at J. Muir & Associates who specializes in commercial litigation, contracts and general counsel.
The most important thing to note about liens is that they are legally binding. In the event of a default, the lender will claim whatever property it has liens on to cover the loan. There are different types of liens that can be invoked in different scenarios, but when it comes to small business loans, the lender and borrower agree on the lien. In most instances, liens secure your loan in the event of a default, which drives down your interest rate.
"The less security or liens you give the lender, the more you're going to pay as a borrower on the loan," Wolfe said. "You're generally not going to find real financing opportunities where there's zero liens."
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Types of liens
Non-repayment of a loan is a common issue that can result in liens being placed on your assets. Here are several kinds of liens you may encounter.
1. Tax lien
This type of lien is placed on your assets when you don't pay your taxes. This is one of the ways the Internal Revenue Service collects unpaid taxes; the federal, state or local government takes a security interest in your property or real estate. Remember, you must pay your tax debt before your mortgage.
2. Consensual liens
When you take out a loan and put up an asset as collateral, you are consenting to have a lien put on your property. This is a common option you'll see when seeking loans from banks.
"It occurs when you agree to give the lender an interest from what you owe as security," said Timo Wilson, CEO of ASAP Credit Solutions. "For example, when you buy a house and you take a mortgage, you're giving the lender a voluntary lien, since there's an added interest to the actual price of it."
3. Judgment lien
These liens are usually the result of a lawsuit. If you fail to repay your debt, a court ruling gives a creditor, lender or lien holder the legal right to take possession of your personal property. This is an involuntary lien, meaning it doesn't require your consent.
4. Mechanic's lien
Although this is a more industry-specific lien, it's important to know how it works. In this case, contractors are typically the lien holders. When you don't pay for work done on your property – such as your home, office or warehouse – you can be hit with a mechanics lien. Let's say a general contractor does work on your property but you fail to pay them – the contractor can then have a lien placed on your property.
Key takeaway: It's important to know what kind of liens may be placed on your assets. You may have a mechanic, judgment, consensual or tax lien depending on whom you fail to pay.
How liens help your business
Liens help drive down interest rates for the debtor. Providing property to offset the risk of the loan assures the lender that they will be able to recoup their money – even if you default – allowing them to charge you lower interest. This can make it more affordable for your business to borrow money to finance specific projects or purchases.
"If a business needed equipment to expand, a bank might extend a loan to purchase the equipment and the loan would be secured by a lien," said Muir. "The money the business earns from the use of the new equipment pays off the loan over time, instead of having to pay one lump sum for the expansion."
Depending on your business's financial situation and available collateral, lenders may still charge you high interest rates, but collateral and liens function to provide favorable loans. If you're interested in financing, know that just about anything can be secured with a lien. However, while it is possible, it may be difficult to find financing if you intend to place multiple liens from different banks on one asset … because most lenders would not agree to accept encumbered property as collateral."
However, multiple liens can end up on the same piece of collateral if a lender doesn't thoroughly scrutinize a business's financial history, according to Muir.
Key takeaway: A lien can be used as collateral against a loan, which may result in lower interest rates.
Risks of liens
As with any major financial decision, it's important to understand the risks involved with your loan agreement. Before you sign, make sure you have a clear understanding of what assets the lender is going to place liens on. If you default and there's a lien on your home, obviously, this could have major negative implications.
"Just like any debt, it is important to weigh the risk and understand that defaulting on the loan could be an expensive choice," Muir said.
Another risk area to be aware of is personal guarantee clauses. Personal guarantees are legally binding agreements that say you will personally pay back the loan if your business can't make its payments. While it is different from a lien, lenders can still establish liens through personal guarantees.
Wolfe provided an example where a business is taking out a loan with a lender, with a lien on a business asset, and the business owner signs a personal guarantee. The business owner may be required to accept another lien on personal assets to secure their business's loan in the event of default. If the business defaults on the loan and the business's collateral doesn't cover it, the lien holder can then liquidate the business owner's personal assets it holds liens on to cover the loan.
Key takeaway: Make sure you understand all the risks involved before taking out a loan, including liens and personal guarantees.
How do you get rid of a lien?
It's important to know how to eliminate a lien and its legal claims against your assets. You can remove a lien by doing the following:
1. Pay off your debt in full.
When you pay down what you owe, there is no longer a need for a lien.
"At that point, a 'release of lien' will be issued, which should be signed at the time of final payment as proof that this payment was made, as well as to serve as an assurance that no judgment will be placed against the property," said Anna Barker, personal finance expert and founder of LogicalDollar.
2. Ask the court to remove the judgment lien.
After you request this, it is up to the court to approve your appeal to eliminate the lien. This decision is determined by the status of your debt.
3. File for bankruptcy.
Filing for bankruptcy is also an option, because it bypasses whatever decisions were made in state court. However, this should be your last resort. You can work with a bankruptcy attorney to help you file for Chapter 7 and extinguish your lien.
"This option is only available to certain liens, such as judicial liens, and may sometimes only be enforceable for a limited amount of time," said Timothy Hansen, founder and CEO of Wealth Growth Wisdom.
Key takeaway: There are a few ways to get rid of a lien or achieve a lien release on your property or assets. You can pay down your debt in full, request removal of your judgment lien or, as a last resort, file for bankruptcy.
There are several ways to finance your business, and each has its own level of risk. To get a traditional loan, you'll have to provide extensive financial information, put up collateral and adhere to lengthy reporting requirements. You can also explore other financing methods, like SBA loans, equity financing, crowdfunding, and mergers and acquisitions.
"If you are in a high-risk business, consider inviting investment rather than incurring debt," Muir said. "Investors accept certain risks that lenders do not accept, and if there is a possibility of default, it may be preferable to share the risk with others."
Key takeaway: Before taking out a loan, explore all your financing options so you can make the best choice for your business and repayment ability.
Matt D'Angelo contributed to the writing and reporting in this article. Some source interviews were conducted for a previous version of this article.