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Understanding the Debtor-Creditor Relationship

Filed under Asset Protection Strategies. Fact checked on May 24, 2012.

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To understand why asset protection is critical, it is important to understand the debtor-creditor relationship and the risks that you may face.

A comprehensive asset protection plan can eliminate or significantly reduce the risks involving in operating a business and shield business and personal assets from the claims of creditors should something go wrong. (While important, asset protection planning is just one aspect of business formation. See our detailed discussion of starting a small business for other factors that you should consider.)

In order to best accomplish the goal of protecting your wealth, you need to be familiar with the nature of the debtor-creditor relationship, including the types of liens creditors can place against your assets. Different types of liens have varying implications and significance in different types of proceedings between debtors and creditors.

Debtor-Creditor Relationships Can Be Voluntary or Involuntary

The world's economy is dependent on billions of debtor-creditor relationships. At every level, goods and services are provided in exchange for a promise, explicit or implicit, to pay for those goods and services.

Almost every individual and business in America either owes money or is owed money, or both. It is these debtor-creditor relationships that make it essential to protect assets from creditors who would seize them to satisfy debts.

Debtor-creditor relationships are created in one of two ways: voluntarily or involuntarily.

Voluntarily. Most of our debtor-creditor relationships arise from voluntary interactions. Examples include loans of all types, credit lines and the use of credit cards. When a person purchases a car and finances the cost, the purchaser is voluntarily incurring debt. The same is true when a credit card is used to purchase goods or services; the purchaser is voluntarily creating a debt to the credit card company by using the card to make the purchase.

In fact, when a person goes into a restaurant and orders dinner, a debt is created because the food is prepared and served by the restaurant in exchange for the diner's implicit promise to pay for it. Both a dinner out and a mortgage on a house create a debt--but the debt to the restaurant is paid immediately. The mortgage, however, illustrates why asset protection is so important. If the payments aren't made, the creditor can often force the sale of the house to satisfy the mortgage debt.

Involuntarily. An involuntary debt arises by operation of law or judicial proceedings. For example, if the employee of a small business is at fault in a traffic accident and injures someone, the business can be required to compensate the injured person. Similarly, if a house painter applies the wrong paint, or damages the carpets, a debt is created. The homeowner may insist that the painter correct the problem or provide compensation for the damage. Involuntary debt is the hidden risk to assets that can't be avoided. The impact of that risk, however, can be minimized.

Creditors have liens against property. The interests that creditors have in the debtor's property are referred to as liens against the property in question.

Creditors with liens are termed "secured creditors." If they are not paid, secured creditors can, in effect, seize your assets to satisfy debts they are owed. Understanding the types of liens and how they work may allow you to avoid them, effectively battle them in court, and possibly invalidate or eliminate them altogether.

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