What is an Encumbrance?

Robinhood Learn
Democratize Finance For All. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

An encumbrance is a legal restriction on an asset, such as a piece of property in real estate, that may affect the transfer of the asset or restrict usage.

🤔 Understanding encumbrances

Encumbrances are commonly found in real estate. Some encumbrances may affect your ability to sell a property, while other types do not affect the value of the land at all. Most encumbrances are claims against a property by a third party. These claims are liabilities for the property owner. In accounting, encumbrances are funds that are reserved in a budget for a specific purpose. These restrictions are common in government accounting to ensure that the money is there when it is time to pay an obligation, such as employee payroll and benefits.

Example

Let’s say a homeowner hires a contractor to renovate and upgrade the kitchen of their house. If the homeowner doesn’t pay the contractor, the contractor may place an encumbrance on the house by filing a mechanic’s lien. This encumbrance is a “hold” against the property. If the homeowner does not settle the mechanic’s lien, a judge may order foreclosure on the house. Money from the sale of the home would satisfy the encumbrance and pay the contractor.

Takeaway

An encumbrance is like an anchor on a boat…

Encumbrances can be a burden on a property. An encumbrance may restrict homeowners from using the property in some way, affect a house’s marketability, or even allow a creditor to seize the property for an unpaid debt. Encumbrances – like an anchor – can weigh a house down until the homeowner settles the claims.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

Tell me more…

What are the two types of encumbrances?

There are two definitions of encumbrance.

In real estate, an encumbrance is a claim against your property by a third party (someone that is not the owner). Some encumbrances can impact a seller from transferring ownership during the sale.

In accounting, an encumbrance is a restriction on funds. The money is set aside in the budget and reserved for a specific obligation, such as a contract.

Encumbrances in real estate

A property can have different types of encumbrances attached to it. Homebuyers need to pay special attention because lenders may refuse to finance a property that has encumbrances.

What are the four types of encumbrances on land?

There are four primary types of real estate encumbrances:

  1. Liens
  2. Deed restrictions
  3. Easements
  4. Encroachments

Liens

Liens are financial encumbrances. A lien is a monetary claim against a property because of an unmet obligation, such as unpaid debt. Liens affect the transfer of title when you sell the house because they give a creditor the right to sell the property to ensure payment.

For example, a tax lien is from the government because the property owner has failed to pay its property taxes. Another common lien is a mechanic’s lien, where a contractor or subcontractor hasn’t been paid for his or her services. Similarly, a lender may file a mortgage lien if the borrower has missed mortgage loan payments.

In each case, the property serves as collateral for outstanding debt. As a result, the lienholder has a security interest in your house and has the legal right to seek payment. Eventually, a judge may order foreclosure on the encumbered property to satisfy the liens and pay the creditors.

Deed Restrictions

A deed restriction is a restrictive covenant or agreement that the seller writes into the deed of a property. It restricts the use of the property or prevents the homeowner from making certain changes to the home.

For example, in historic districts, a home may have a deed restriction where the owner cannot change the historical elements of the house, such as the original facade of a building. Other deed restrictions may say that you can only park your cars in a particular area on the land.

Deed restrictions are meant to protect property values or maintain a standard of use from owner to owner.

Easements

An easement is a legal right for a third party to use a property in some way. For example, a utility company may have a utility easement so that it can place and maintain power lines on your land.

Another example is if your neighbor’s home is land-locked (the property has no direct access to it, such as from a public road). Your neighbor may have an easement to cross your land to get to theirs.

Encroachments

Another type of encumbrance is an encroachment. That is when a third-party has a structure that crosses the property line onto your land.

For example, if your neighbor’s shed is over the lot line, it is an encumbrance on both parties until they fix the issue. It is an encumbrance for you because the structure prevents your free use of your land. It also encumbers your neighbor because he doesn’t have the title to the land that he built his shed on.

What distinguishes a lien from other types of encumbrances?

A lien is a common type of encumbrance, but not all encumbrances are liens. Of all the encumbrance types, a lien refers explicitly to a monetary claim against property and can decrease the value of the property.

Liens can affect the transfer of property because most lenders won’t finance a home loan that doesn’t have a clear title (a title without liens). The creditors, or lienholders, have the right to take legal action to force the homeowner to pay the outstanding debt. That is why lenders require a title report as part of the home buying process. This report reveals all liens, easements, encroachments, and anything else in the country records against the property.

Similarly, homebuyers also get a title insurance policy to protect them from issues that the title report may have missed. So, if six months after you purchase a home, you find out that there are years of unpaid taxes on the property, your title insurance will kick in and cover the legal fees to resolve the issue.

Other encumbrances can be non-financial. They may just be an inconvenience to the new owner, although it may affect a property’s marketability. For instance, a lender may be willing to finance a house with an easement that lets your neighbor cross the property. But, the potential homebuyer may not necessarily want this and choose to back out of the sale.

How do you get an encumbrance?

To get an encumbrance for unpaid debt, you’ll need to file a lien in the county where the property is located in. The procedures, laws, and rules around filing for liens vary in every state and locality –- Talk to the country clerk to get details.

To get a deed restriction on your property, you’ll likely need to fill out an application and record it with the county clerk. Some localities have templates or agreements that you can fill in with the relevant information.

Similar to a deed restriction, to get an easement, you’ll need to record the agreement with the county clerk. Both the property owner that is granting the easement and the person using the easement must sign the document. Both the deed restriction and easement forms need a notary’s signature as well.

Finally, if your neighbor is encroaching on your property, you’ll need to resolve it with them. One option is to grant an easement (usually with some type of financial compensation to you). You could also take legal action to remove the encroaching property in civil court.

Encumbrances in Accounting

Another type of encumbrance relates to accounting –- In finance, an encumbrance is money that is set aside to pay a specific obligation or liability. It helps prevent overspending by making sure that the funds are reserved and ready when they are needed.

What is the difference between encumbrances and accounts payable?

An encumbrance account holds funds for a purpose, and the bill is not due in the future. For example, if a business places an order, but the company has not received the goods yet, the funds are encumbrances – They are available for the purchase when the order and bill arrive.

On the other hand, accounts payable is money that is owed. The company has already received the goods but has not paid the bill yet.

What is the difference between an encumbrance vs. an appropriation vs. an expenditure?

In government accounting, the budget is a legal requirement. Appropriations, encumbrances, and expenditures must follow a strict process in governmental accounting. On the other hand, in the private sector, the budget functions more as a management tool to assess operations, so these three terms may not always apply.

Appropriation is an amount set aside from the budget to pay for specific items. In governmental accounting, you estimate your appropriations for general categories at the beginning of the year.

When contracts and obligations come up, encumbrances reserve a specific amount from the appropriations. Encumbrances usually come up after you initiate a purchase order. The encumbrances amount stays on an accounting balance sheet but is reported as assigned, committed, or restricted.

Expenditures are bills, invoices, or charges. Many expenditures need to be encumbered before they are paid.

For example, let’s say a business has a budget of $1M. It appropriates $300,000 for equipment. The owner signs a purchase order for $250,000 in new equipment, deliverable in one month. $250,000 is now encumbered to pay this contract in one month. When the bill arrives, it is an expenditure that can now be paid using the encumbered funds.

Ready to start investing?
Sign up for Robinhood and get stock on us.Certain limitations apply

New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

20200312-1118645-3364615

Related Articles

You May Also Like

PARTICIPATION IS POWER™

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Commission-free trading of stocks, ETFs and options refers to $0 commissions for Robinhood Financial self-directed individual cash or margin brokerage accounts that trade U.S. listed securities and certain OTC securities electronically. Keep in mind, other fees such as trading (non-commission) fees, Gold subscription fees, wire transfer fees, and paper statement fees may apply to your brokerage account. Check out Robinhood Financial’s Fee Schedule for details.

Brokerage services are offered through Robinhood Financial LLC, (RHF) a registered broker dealer (member SIPC) and clearing services through Robinhood Securities, LLC, (RHS) a registered broker dealer (member SIPC). Cryptocurrency services are offered through Robinhood Crypto, LLC (RHC) (NMLS ID: 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. The Robinhood spending account is offered through Robinhood Money, LLC (RHY) (NMLS ID: 1990968), a licensed money transmitter. A list of our licenses has more information. The Robinhood Cash Card is a prepaid card issued by Sutton Bank, Member FDIC, pursuant to a license from Mastercard®. Mastercard and the circles design are registered trademarks of Mastercard International Incorporated. RHF, RHY, RHC and RHS are affiliated entities and wholly owned subsidiaries of Robinhood Markets, Inc. RHF, RHY, RHC and RHS are not banks. Products offered by RHF are not FDIC insured and involve risk, including possible loss of principal. RHC is not a member of FINRA and accounts are not FDIC insured or protected by SIPC. RHY is not a member of FINRA, and products are not subject to SIPC protection, but funds held in the Robinhood spending account and Robinhood Cash Card account may be eligible for FDIC pass-through insurance (review the Robinhood Cash Card Agreement and the Robinhood Spending Account Agreement).

2784249

© 2024 Robinhood. All rights reserved.
Follow us on

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.

Commission-free trading of stocks, ETFs and options refers to $0 commissions for Robinhood Financial self-directed individual cash or margin brokerage accounts that trade U.S. listed securities and certain OTC securities electronically. Keep in mind, other fees such as trading (non-commission) fees, Gold subscription fees, wire transfer fees, and paper statement fees may apply to your brokerage account. Check out Robinhood Financial’s Fee Schedule for details.

Brokerage services are offered through Robinhood Financial LLC, (RHF) a registered broker dealer (member SIPC) and clearing services through Robinhood Securities, LLC, (RHS) a registered broker dealer (member SIPC). Cryptocurrency services are offered through Robinhood Crypto, LLC (RHC) (NMLS ID: 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. The Robinhood spending account is offered through Robinhood Money, LLC (RHY) (NMLS ID: 1990968), a licensed money transmitter. A list of our licenses has more information. The Robinhood Cash Card is a prepaid card issued by Sutton Bank, Member FDIC, pursuant to a license from Mastercard®. Mastercard and the circles design are registered trademarks of Mastercard International Incorporated. RHF, RHY, RHC and RHS are affiliated entities and wholly owned subsidiaries of Robinhood Markets, Inc. RHF, RHY, RHC and RHS are not banks. Products offered by RHF are not FDIC insured and involve risk, including possible loss of principal. RHC is not a member of FINRA and accounts are not FDIC insured or protected by SIPC. RHY is not a member of FINRA, and products are not subject to SIPC protection, but funds held in the Robinhood spending account and Robinhood Cash Card account may be eligible for FDIC pass-through insurance (review the Robinhood Cash Card Agreement and the Robinhood Spending Account Agreement).

2784249

© 2024 Robinhood. All rights reserved.