What is a 'Security Interest'

A legal claim on collateral that has been pledged, usually to obtain a loan. The borrower provides the lender with a security interest in certain assets that can be repossessed if the borrower stops making loan payments. The lender can then sell the repossessed collateral to pay off the loan. Granting a security interest is the norm for loans such as auto loans, business loans and mortgages; these are called secured loans. Credit cards, however, are unsecured. The credit card company will not repossess the clothes, groceries and vacation you purchased on the card and haven’t paid off yet.

BREAKING DOWN 'Security Interest'

A transaction in which a security interest is granted is called a secured transaction. The Uniform Commercial Code specifies that the three requirements for a security interest to be legally valid are (1) the security interest is given a value, (2) the borrower owns the collateral and (3) the borrower has signed the security agreement. The collateral must be specifically described in the agreement (e.g., the borrower’s 2013 Honda Accord, not “all of the borrower’s vehicles”). The lender must also “perfect” its security interest to make sure no other lender has rights to the same collateral.

Here is an example of how a security interest works. Let’s say Sheila borrowed $20,000 to buy a car and stopped making payments when her loan balance was $10,000 because she lost her job. The lender repossesses her car and sells it at auction for $10,000, which satisfies Sheila’s loan balance. Sheila no longer has her car, but she also no longer owes the lender any money. The lender no longer has a bad loan on its books.

Another situation where a lender might require the borrower to grant a security interest in assets before it will issue the loan is when a business wants to borrow money to purchase machinery. The business would grant the bank a security interest in the machinery, and if the business is unable to make its loan payments, the bank would repossess the machinery and sell it to recoup the money it had lent. If the business stopped paying its loan due to bankruptcy, its secured lenders would have precedence over the business’s unsecured lenders in making claims on the business’s assets.

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