A security interest reduces your lender’s risk since they can sell the collateral to recoup some of the money lost. Understanding a security risk will help you make better decisions when using it in a loam agreement.
Definition and Example of a Security Interest
A security interest is a legal claim your lender has to any collateral you put down to obtain a loan. If you agree to a security interest and eventually default on your loan, your lender has the right to take possession of your collateral. It’s common to grant a security interest on loans that come with collateral requirements, like mortgages and auto loans. For instance, if you take out a mortgage, your closing documents will grant your lender security interest in the home you’re purchasing. This security interest gives your lender the right to repossess the house if you default on your mortgage.
How Does a Security Interest Work?
A security interest allows your lender to take possession of the collateral if you default on your loan. However, the lender can only do that if the security interest is valid. The Uniform Commercial Code (UCC) outlines three criteria a security interest must meet to be considered legally valid:
You signed a security agreement granting rights to the secured party (lender)A value is assigned to the collateral by the secured partyYou (the debtor) have ownership of the collateral
The lender must also perfect the security interest, which means they ensure that no other creditors have a claim to the collateral. The exact steps your lender takes to perfect the security interest can vary depending on where you live.
Secured Loans vs. Unsecured Loans
So if you stop making payments on your auto loan, your lender can repossess the car and sell it to recoup any lost money. The collateral requirements make secured loans less risky to your lender, so they often come with lower interest rates. In comparison, an unsecured loan, like a credit card, doesn’t have collateral requirements. If you default on your credit card, your lender can start the debt collection process, but there’s no collateral to repossess. This lack of collateral makes unsecured loans riskier to your lender and often results in higher interest rates.
