What is a 'Security Interest'

Security interest is 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

BREAKING DOWN 'Security Interest'

A security interest is an enforceable claim or lien which gives a creditor the right to repossess all or part of a property secured as collateral for a loan. Securing interest on a loan lowers the risk for the lender and, in turn, allows the lender to charge lower interest, thereby, lowering the cost of capital for the borrower.

A transaction in which a security interest is granted is called a secured transaction. Granting a security interest is the norm for loans such as auto loans, business loans and mortgages; these are collectively called secured loans. Credit cards, however, are classified as unsecured loans. The credit card company will not repossess the clothes, groceries or vacation you purchased on the card you default on.

The Uniform Commercial Code (UCC) 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, for example, the security listed in the loan agreement might specify 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. A perfected security interest is any secure interest in an asset that cannot be claimed by any other party. The interest is perfected by registering it with the appropriate statutory authority so that it is made legally enforceable and any subsequent claim on that asset is given a junior status.

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 and equipment. 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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