Secured Debts

Secured debt

A creditor's claim that is secured by a lien of some type in a debtor's property either by the debtor's own agreement or involuntarily with a court judgment or taxes.

Some examples include mortgages, equity lines of credit, and vehicle and equipment loans. Other kinds of debt that are often secured by liens on property include Purchase-money security interest, judgment liens, tax liens, and blanket security liens.

What Is Secured Debt?

Secured debt is debt backed or secured by collateral to reduce the risk associated with lending. If the borrower on a loan defaults on repayment, the bank seizes the collateral, sells it, and uses the proceeds to pay back the debt. Assets backing debt or a debt instrument are considered as a form of security, which is why unsecured debt is considered a riskier investment than secured debt.

A "secured debt" is an obligation you owe that's backed by collateral a creditor can recover if you default. ("Default" means failing to follow the contract terms, such as making the required payments.)

Secured debts are created with liens. Liens can be voluntary or involuntary. Home mortgages and car loans are examples of secured debts that you incur voluntarily. Real property tax lienss, by contrast, are involuntary liens.

What Is a Voluntary Lien?

Usually, you voluntarily agree to give a creditor a security interest in your property. For instance, as a condition for making a home loan, a lender will typically require you to sign a mortgage (or in some states, a deed of trust). A mortgage or deed of trust is an agreement that grants a lender a security interest, or lien, against real property. It's the lien that allows for a foreclosure auction if the homeowner falls behind on the monthly payment.

You also can grant a lender a lien against personal property, which is anything that you own or have an interest in that isn't real estate (real property). Personal property includes such things as vehicles, equipment, furniture, tools, inventory, shares of stock, other types of investment interests, and even cash.

Typically, the way you grant a lien against personal property is through a security agreement. Before extending a new car loan, for example, a lender will require you to sign a security agreement that grants it a lien against the vehicle that you are buying. It's the voluntarily lien that allows the lender to repossess your car if you don't pay as agreed.

What Is an Involuntary Lien?

Involuntary liens are security interests imposed against your property by a state or federal statute or through a court order. No agreement is involved. Involuntary liens include:

real estate or income tax liens
mechanic's liens
landlord liens (in some states), and
judgment liens.

How a Creditor "Perfects" a Lien

One of the steps that a secured creditor must take to protect its right to collect is to perfect its lien. "Perfection" is a legal term that refers to the action required to give other creditors and interested parties notice of a lien or security interest. The action required to perfect a lien depends on the type of property and applicable state law. For example:

Real Property

In most states, the lender perfects its lien by recording (filing) mortgages and deeds of trusts in the county where the property is located.

Vehicles

Lenders usually can perfect liens against cars, motorcycles, and trucks by a filing with the state motor vehicle department and a notation on the certificate of title.

Tangible Personal Property

Security interests in most tangible personal property—like equipment, furniture, tools, goods, and materials—are perfected by filing financing statements. A financing statement is a document that identifies the borrower, lender, and collateral for a secured debt.

Unlike security agreements, financing statements don't have to signed to be effective. A creditor can file a financing statement as long as you have signed the security agreement for the collateral that it is supposed to cover. In most states, financing statements are filed with the secretary of state.

Perfecting a lien is a critical step for any creditor. In some cases, borrowers grant liens against the same property, like your home, to multiple creditors. Take, for example, a home equity line of credit, which is usually junior to the mortgage that you took out to buy your house. A junior lien, like a home equity line of credit, can, in effect, move up in priority if the holder of the first mortgage fails to perfect its interest.

In bankruptcy, the consequences of a lender's failure to perfect a lien can be even more serious. If you file bankruptcy, the court has the power to set aside a lien that has not been properly perfected. A lien that is set aside is treated as if it never existed in the first place—meaning that the lender becomes an unsecured creditor.

How a Creditor Can Collect a Secured Debt

One of the big differences between an unsecured debt and a secured debt is how the creditor can enforce its rights if you fail to make payments. For most unsecured debts, creditors must first sue you in court before they can take any of your property. A secured creditor, however, can move to enforce is rights if you default on your loan obligations and have not filed bankruptcy. Remedies to enforce secured debts include:

Repossession

Secured creditors may not trespass on private property or breach the peace, but they usually don't have to go to court before repossessing cars or other motor vehicles.

Foreclosure

A lender may enforce a home loan by foreclosing its mortgage or deed of trust. In some states, foreclosure doesn't require any court action and may be completed within a matter of a few months. In other states, where court approval is needed, foreclosure typically takes much longer.

Court action

A secured creditor has the additional option of filing a court action to obtain a judgment against you. Depending on applicable state law, a creditor may seek a judgment for the entire obligation that you owe or the balance left after deducting the value of any collateral that it recovers.

KEY TAKEAWAYS

Secured debt is debt that is backed by collateral to reduce the risk associated with lending.
In the event a borrower defaults on their loan repayment, a bank can seize the collateral, sell it, and use the proceeds to pay back the debt.
Because loans that are secured have collateral backing them, they are considered less risky than loans that are unsecured, or that have no collateral backing.
The interest rate on secured debt is lower than on unsecured debt.
In the event of a company's bankruptcy, secured lenders are always paid back before unsecured lenders.

Understanding Secured Debt

Secured debt is debt that will always be backed by collateral, which the lender has a lien on. It provides a lender with added security when lending out money. Secured debt is often associated with borrowers that have poor creditworthiness. Because the risk of lending to an individual or company with a low credit rating is high, securing the loan with collateral significantly reduces that risk.

For example, let's say Bank ABC makes a loan to two individuals with poor credit ratings. The first loan is backed by collateral whereas the second loan is not. After three months, both borrowers cannot make payments on their loans and default. With the first loan, backed by collateral, the bank is legally allowed to seize that collateral. After they do, they sell it, usually at auction, and use the proceeds to pay back the outstanding portion of the loan.

In the second loan, where there is no collateral backing it, the bank has no collateral to seize to pay back the outstanding debt. In this case, they will have to write-off the loan as a loss on their financial statements.

When a loan is secured, the interest rate that is offered to the borrower is often much lower than if the loan was not secured. Sometimes, when a loan does not necessarily require collateral, such as a personal loan, it can be in the interest of a borrower to put up a form of collateral to receive a lower interest rate. They should only do this if they are sure that they can continue to pay back the loan or are willing to lose the collateral if they cannot.

Priority of Secured Debt

If a company files for bankruptcy, its assets are listed for sale to pay back its creditors. In the payback scheme, secured lenders always have priority over unsecured lenders. The assets are sold off until all secured lenders are fully paid back, only then are unsecured lenders paid back.

If the assets are sold and there are not enough proceeds left to pay back unsecured lenders, they are left at a loss. If there are not enough proceeds to pay back the secured lenders, depending on the situation, secured lenders can go after other assets of the company or individual.

Examples of Secured Debt

The two most common examples of secured debt are mortgages and auto loans. This is so because their inherent structure creates collateral. If an individual defaults on their mortgage payments, the bank can seize their home. Similarly, if an individual defaults on their car loan, the lender can seize their car. In both cases, the collateral (the home or the car) will be sold to recoup the outstanding debt.

For example, Mike takes out a $15,000 car loan from a bank. The loan is a secured debt because the car acts as the collateral that the bank can seize if Mike defaults on his loan repayments. After two years, there is still $10,000 left to pay on the loan, and Mike suddenly loses his job. He can no longer make the loan payments and so the bank seizes his car.

If the current market value of the car is $10,000 or more, when the bank sells it and collects the proceeds, it will be able to cover the remaining debt. If the market value of the car is less than $10,000, say, $8,000, the bank will cover $8,000 of the outstanding debt but will still have $2,000 of the debt remaining. Depending on the situation, the bank can go after Mike for this remaining $2,000 in debt.