A security interest is a lien on an asset that has been pledged as collateral on a loan by a borrower. The lender can use this security interest to claim the asset if the borrower defaults on a loan agreement, thereby paying off the loan. Security interests are common with any asset-based lending, such as mortgages and car loans. For example, Mr. Smith takes out a $300,000 loan to buy a townhouse, with the townhouse as collateral on the loan. The lender takes out a lien on the property. Mr. Smith then stops making loan payments, so the lender uses its security interest in the property to take possession and sell it. The proceeds are then used to pay off the loan.
A security interest allows a lender to take precedence in being paid back if a borrower goes bankrupt. In this situation, the secured lender is paid first, while unsecured creditors are paid if there are any residual assets left. An advantage of having a security interest from the perspective of the borrower is that the lender’s risk is reduced, so that a lower interest rate may be offered.