Assets can be unencumbered, or they can have outstanding claims against them. For example, a house with no mortgage is unencumbered. Encumbrance is important for understanding cash flow and whether an asset is in a controlled position or not.
If there is outstanding debt or a lien on an asset, then the asset is considered encumbered. It's that simple.
Encumbered assets have more friction to liquidate them – you need to pay off the mortgage when you sell a house, which adds time and paperwork over selling an unencumbered asset like a paid off car. Not to mention mechanic's liens, which complicate selling processes immensely.
Cash Flow and Encumbrance
In personal finances, debt-based encumbrances have implications on your cash flow. If you look at your net-worth only, you are missing the encumbered half of the picture. I've written about why I dislike tracking net-worth in this article:
Net worth masks encumbrances, which can be dangerous to your personal financial health if you are over-extended on debts.
Too many debts shorten your cash runway and make you fragile to any upsets in income cash flow.
If you lose an income stream, you're suddenly thrust into the mad scramble of coming up with cash quickly to fuel your debts. Massive net worth can crumble and be lost due to that hiccup in cash flow.
This is why I advocate so often for tracking your cash flow. Many debt-based encumbrances will show up there.
A Note on Property Tax Lien Investing to Takeover Properties
You might be wondering why encumbered assets without debt are important to consider. Here's one case:
Property tax liens are liens that can be placed on your property for failing to pay property taxes.
Even if you own your house free and clear, it can become encumbered by missing taxes. This then opens you up to a particularly evil form of predation: property tax lien investors.
From an article I read about TikTok investment advice:
Earlier this year, another TikTok user, @ayehxncho, attracted the internet’s ire when he promoted tax liens as “the new #1 side hustle.” He boasted of allegedly looking on local websites for homeowners who were behind on their property taxes. By paying taxes on the homes, he could put the homeowners in his debt and evict them if they didn’t repay him, he said. “I know a lot of people say, ‘Why would you take their house?’” he said. “If you don’t do it, the banks will. You either eat or you starve.”
– from The Daily Beast
In short, property tax lien investors are financial predators who target people already behind on their taxes – normally, that's people experiencing financial duress who don't have cash to pay off a lien.
These investors leverage lien laws to transfer that encumbered asset to their ownership. It's not theft, but it's a strategy that won't win them any friends.
Some people find comfort in the knowledge that they own their assets free and clear. Others see encumbrance as a way of getting ahead, leveraging their lifestyle to fund further profits.
No matter where you lie on that spectrum, it's important for you to understand the difference between unencumbered assets and encumbered ones, and to track your cash flow associated with them.
If you're interested in reading more of my articles, I shall call to attention this recent article about my return to university: