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.

RELATED TERMS
  1. Collateral

    Collateral is property or other assets that a borrower offers ...
  2. Secured Note

    A secured note is a type of loan that is backed by the borrower's ...
  3. Unsecured Loan

    An unsecured loan is a loan that is issued and supported only ...
  4. Additional Collateral

    Additional assets put up as collateral by a borrower against ...
  5. Asset Financing

    Asset financing uses a company’s balance sheet assets, including ...
  6. Secured Creditor

    A secured creditor is any creditor or lender associated with ...
Related Articles
  1. Insights

    Forces Behind Interest Rates

    Get a deeper understanding of the importance of interest rates and what makes them change.
  2. Investing

    Commercial real estate loans

    Obtaining a commercial real estate loan is quite different from borrowing for residential real estate. Here's what to expect and how to get what you need.
  3. Personal Finance

    Home Improvement Loans: What Are Your Best Options?

    If you plan on taking out a home improvement loan, you should know what your options are and which ones might be best for your situation.
  4. Personal Finance

    Personal Loans: Consider These Alternative Lenders

    Looking for an alternative source of financing for a personal loan? Take a look at these companies.
  5. Small Business

    Answer These 7 Questions Before Applying for a Loan For Your Startup

    Learn the seven key questions every budding entrepreneur needs to have answers to before sitting down with a lender to discuss a startup loan.
  6. Personal Finance

    Should You Lend Money to Family or Friends?

    Find out how loaning cash to help family or friends can put a strain on your relationship and your bank account. Learn how to make family loans safer.
  7. Personal Finance

    Can't Get A Bank Loan? Turn To Your Neighbor

    Peer-to-peer lending can be an inexpensive way to gain access to credit when banks are restricting lending -- but you need to understand the entire deal first before jumping in.
  8. Personal Finance

    A Good Credit Score: Why Do You Need It?

    Your credit score can affect your ability to borrow money, buy a house or even get a job.
  9. Investing

    How to Get the Money to Flip a House

    If you want to get into house flipping but don't have the cash to invest, read on for options.
  10. Personal Finance

    Getting A Mortgage: How The Process Has Changed

    After the banking crisis, banks have tightened their lending standards. Find out how the current mortgage-lending standards have changed in the last five years.
RELATED FAQS
  1. What is the difference between secured and unsecured debts?

    Learn about the differences between secured and unsecured debt — and how banks buffer risks associated with each type of ... Read Answer >>
Trading Center