Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.
Updated April 07, 2021Security interest is an enforceable legal claim or lien on collateral that has been pledged, usually to obtain a loan. The borrower provides the lender with a security interest in certain assets, which gives the lender the right to repossess all or part of the property if the borrower stops making loan payments. The lender can then sell the repossessed collateral to pay off the 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, 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 with the card on which you default. Signature loans are another example of unsecured loans. The main difference between these two types of loans is the absence or presence of collateral.
The Uniform Commercial Code (UCC) specifies three requirements for a security interest to be legally valid, a process known as “attachment.”
Further, the collateral must be specifically described in the security 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. As a note, a deed of reconveyance proves that a bank no longer has a security interest over a property.
A perfected security interest is a secure interest in an asset owned solely by the borrower and must be registered with the appropriate statutory authority.
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 in which 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 its unsecured lenders in making claims on its assets.