Security for a Loan

If you loan money to someone, whether to an individual or to a business, you should try to obtain security (collateral) for your loan, in case the borrower defaults.  When you buy a car, if you finance the purchase, the lender puts a “lien” on your vehicle title, which allows the lender to repossess your car is you do not pay the loan.

There are various forms of “security” for a loan, including:

  • Mortgage on real estate
  • Security Interest in Personal Property
  • Stock Pledge
  • Personal Guaranty

Mortgages:  Most home loans are secured by mortgages, which allow the lender to take back the property if the loan is not repaid.  Mortgages can also be used to secure loans that are not used to purchase the property.  If you make a business loan to a friend or relative, the loan can still be secured by a mortgage on real estate owed by the borrower or someone related to the borrower.  For example, if you loan your friend money for use in his business, you could secure your loan by putting a mortgage on  your friend’s house or other real estate owned by your friend.  The real estate does not have to be owned by the borrower so long as the owner of the real estate signs the mortgage.  This type of mortgage is know as a “collateral mortgage.”

Security Interests:  A security interest creates a lien in personal property to secure a debt.  The best example of a security interest is a motor vehicle purchase transaction.  If you finance the purchase of your car, the lender will create a security interest in the vehicle by placing a lien on your title.  This lien is endorsed on the title by the Department of Motor Vehicles and can only be removed when the loan is fully paid.  Other personal property can be subject to security liens.  For example, a loan to a business can be secured by a lien on the business assets.  For a restaurant business, a lender might place a lien on the restaurant equipment, tables, chairs, furniture and fixtures.  These liens are created by having the borrower sign a “Security Agreement” and by filing a financing statement (Form UCC-1) with the Department of State.  This filing puts the world on notice that the lender holds a lien on the specified assets.  This effectively prevents the borrower from selling the assets without first paying the loan since the lien would remain on the assets in the hands of any purchaser until the loan is repaid.  These types of security interests are most commonly used in commercial transactions.

Stock Pledge:  Shares of stock or other business ownership interests can be pledged as security for a loan.  For example, lets say that the borrower owns 10,000 shares of stock in General Motors.  The borrower could pledge the shares of stock as security for a business loan.  This is not uncommon.  Often, the shares of stocks in the borrower’s business are pledged as security for a loan to the business.  This typically happens when the Buyer of the business obtains financing from the Seller to purchase the business; in such cases, the financing is often secured by a pledge back to the Seller of the stock of the business.

Personal Guaranties:  A personal guaranty, in its simplest form, is a promise by one person to answer for the debt of another.  Commercial loans to small business entities are also secured by personal guaranties signed by the individual owners of the business in favor of the lender.  This allows the lender to collect from the guarantor in the event the borrower does not pay the loan.  Personal guaranties can also be used in non-commercial transactions.  A loan to an individual can be secured by a personal guaranty by another individual.  A parent is sometimes asked to personally guaranty the debt of a child.  Personal guaranties are often required in lease transactions where the proposed tenant might not be fully creditworthy standing alone.  In commercial transactions, personal guaranties are usually required because business entities are typically “limited liability” enterprises, meaning that they could pose a collection risk to the lender.  A personal guaranty given by the individual owner of the business further protects the lender.

Lenders should always be looking for security before making a loan.  Especially in personal transactions, loans without security can be risky.  Always consider obtaining adequate security before making any loan.

– Kevin Palmer


Posted in Finance / Taxes, Newsletters