In our prior blog posts, we have examined certain types of debt. First we learned about priority debts. Next, we learned about nondischargeable debts. Now we will turn our attention to secured and unsecured debts.
The difference between an unsecured debt and a secured debt is whether or not the borrower pledges something as “collateral” to “secure” repayment of the debt.
An unsecured debt is simply a garden-variety debt of the simplest nature. For instance, if I loan my friend $100 and he promises to pay me back next week, this is an unsecured debt. On the other hand, a secured debt is characterized by an additional instrument known as a Security Agreement. A Security Agreement gives the lender certain rights in some property owned by the debtor. This property is known as collateral. For instance, if I loan my friend $500 to be repaid next week, he might pledge his bicycle as collateral for the loan. If my friend promises that I can have his bicycle if he fails to repay me, then we have entered into a Security Agreement with respect to the bicycle, and my loan to my friend is secured by the bicycle.
Most people are familiar with secured loans because they have purchased a house or a car at some point in their life. Unless you have saved up enough money to pay the entire purchase price for a house when you buy it, you will have to borrow money to buy the house. Generally you visit a bank and apply for a loan. The bank reviews all of your financial information, processes your loan application, and agrees to provide a loan to you. In exchange, the bank asks you to sign a large number of documents.
Two of these documents are particularly important: First, a Promissory Note; Second, a Deed of Trust. The Promissory Note is simply the borrower’s promise to repay the loan. The Promissory Note does not create a secured debt; it merely creates an unsecured debt. The second instrument, the Deed of Trust, changes the loan from an unsecured loan to a secured loan. In the Deed of Trust, also known as a Mortgage, the borrower pledges the house as collateral. In effect, the borrower promises the bank that if he or she fails to repay the loan, the bank can take the house. The process of taking the house is known as foreclosure, and it secures the bank’s right to repayment.
A car loan is another type of secured loan. If you finance the purchase of a vehicle, you execute a Promissory Note to the lender as well as a Security Agreement. The Security Agreement gives the lender the right to repossess your car if you do not repay the loan. When the collateral in question is personal property, such as a car or some other tangible property, then you use a Security Agreement to create a security interest. When the collateral is real property, such as a house or some other land, you use a Deed of Trust to create a security interest.
A lender who obtains a Deed of Trust or a Security Agreement is generally considered a Secured Creditor. However, the lender must take one extra step in order to perfect the security interest. Perfecting the security interest means giving notice to everybody in the entire world of your security interest. That way, a borrower can’t use the same asset as collateral for a separate debt. A lender will perfect its Deed of Trust by recording it at the Register of Deed’s office. A lender will perfect its security interest and personal property by filing a UCC Financing Statement with the Secretary of State’s office. If a lender fails to perfect its security interest, and if a subsequent lender perfects its security interest before the prior lender, then the second lender’s rights to the collateral are senior to the prior lender. This isn’t a problem as long as the collateral is valuable enough to secure both loans, but when the combined value of the loans is greater than the value of the collateral, one or the other of the two creditors won’t be fully secured. If the borrower defaults, the collateral will not generate enough revenue to pay off both secured debts. For this reason, creditors almost always perfect their security interest as soon as it arises.
Promissory Notes, Security Agreements, and Deeds of Trusts are complex legal instruments. Although parties can and do prepare these instruments themselves, this increases the possibility that they will not be prepared correctly and will be legally invalid. In many cases, invalid loan instruments are unenforceable. For this reason, lenders and borrowers should consult with an attorney if they are considering entering into a loan. The attorney can draft the documents or review them and make sure that they are accurate and legally enforceable in all regards. Carter & Carter will happily prepare your loan instruments or review loan instruments before you sign them. Email us or call (910) 763-3626.