Creditors are not entitled to claims on unencumbered assets since there aren't any debts associated with them. Therefore, these assets are the complete possession that belongs to the person(s) identified in the capacity of the owner(s) in the official capacity, such as on a title deed. The unencumbered assets are not used as collateral for any loan or are subject to competition claims, like past property taxes.
For most consumers, specifically young couples or recent graduates, the most valuable assets, like cars and real estate, will likely not be free from debt. This is because they are usually financing, which results in the purchase of debt using the asset as collateral. As time passes and the car loan or mortgage is paid back, these assets are free of debt. Title searches are an essential element of due diligence when buying real estate or a second-hand vehicle to verify that the asset isn't encumbered or is in possession of outstanding liens.
Working
If an asset is free of any encumbrances, it means it's free and free of legal claims or liens from financial institutions or government agencies. The person listed in the document is solely the owner, and the asset can be transferred or sold to a new owner. For instance, the homeowner who has paid the mortgage completely will own the property free and clear. They can easily sell the house to an incoming homeowner.
A car is another illustration of an asset that could be free from debt. When someone purchases a vehicle and then finances it using an auto loan, later paying it off in full and owning the vehicle in its entirety. If the owner fails to make their loan repayments or pay the loan in full, they could lose the car to the financing company. The company may take it over as collateral. If you're purchasing a used vehicle, it's likely to be free of debt, but it wouldn't harm to ask the seller or financing firm to investigate the title.
Example
Margaret is a recent student now employed by a major pharmaceutical company. In the past, an opening was presented to her to purchase an apartment in a two-bedroom house in the city. She decided to take it with a portion of her savings and the loan her bank was able to approve to purchase the apartment. After a couple of years, the property's value grew significantly, and Margaret was keen to make the most of the increase. However, the property was in a bind, making it difficult for her to sell the property. She decided to request her mother for the portion of the mortgage to release the property from it. After paying the bank, she had an unencumbered house that she could sell quickly.
Why Does Unencumbered Matter?
Encumbrances offer protection to bond investors in the event of default or bankruptcy. In particular, it's crucial to remember that debentures are not subject to any encumbrances, which means they're not secured with particular pieces of collateral or property. However, they have a general claim to the earnings and assets from the company that issued them. If the issuer was to liquidate, holders of the bonds have a right to claim the assets that are not specifically committed to secure debt. Therefore, these assets can lower the chance of a debt default if they are insolvent.
Creditworthy companies usually don't have a reason to secure specific assets to be able to sell bonds because they'll still have very lower interest. (This is why debentures that don't have an encumbered asset attached may occasionally fetch more than bonds with encumbrances of less trustworthy issuers.) Some issuers prefer to keep their assets unbounded to allow future financing.
Special Considerations
In most bankruptcy cases involving liquidations, the assets encumbered are considered to belong to the people who have ownership rights over the asset via the encumbrance. This permits the institution to recover a portion of the losses by the acquisition and the possibility of a later sale of the asset in question. In some instances, non-encumbered assets don't have a predetermined owner if they are liquidated during bankruptcy. This permits the value of liquidated assets not encumbered to be distributed to creditors who have extended credit with unsecured terms. In certain instances, the IRS or the state and local taxing agencies can put a lien on the unoccupied property to collect the tax due.
