Overview

Common security interests are the backbone of secured lending: they convert a lender’s unsecured repayment claim into a prioritized legal right against specific borrower assets. These rights are created by collateral (grant) clauses in loan documents and made effective against third parties through perfection steps such as recording a mortgage or filing a UCC‑1 financing statement.

Legal framework and key terms

  • Granting clause: The provision in a loan agreement that gives the lender a security interest in described assets.
  • Perfection: The act that makes a security interest effective against third parties (examples: recording a mortgage in real‑property records; filing a UCC‑1 financing statement with the state secretary of state; or obtaining “control” of certain deposit accounts or investment property).
  • Priority: Rules that determine which creditor gets paid first from collateral. Generally, the first to perfect or record wins, though exceptions (like purchase‑money security interests) can change priority outcomes.

See UCC Article 9 for state law rules on personal‑property security interests: https://www.law.cornell.edu/ucc/9. For consumer protections and plain‑language guides, see the Consumer Financial Protection Bureau: https://www.consumerfinance.gov/.

How collateral clauses work in practice

  1. Describe the collateral clearly. A good collateral description identifies asset types and—when appropriate—specific serial numbers, account numbers, or schedules. (Vague descriptions create enforcement and perfection problems.)
  2. Create the security interest in the loan document (grant clause) and take steps to perfect it. Perfection methods vary by collateral type and state law.
  3. Monitor value and compliance. Lenders should re‑value or require periodic reports for fluctuating collateral (inventory, receivables, IP) and ensure insurance and maintenance obligations are met.

Priority basics and special rules

  • First‑to‑file/perfect: For many types of personal property, priority goes to the first secured party to file a financing statement or otherwise perfect their interest.
  • Purchase‑money security interest (PMSI): A PMSI can receive super‑priority for certain collateral (e.g., inventory or equipment) if statutory rules are followed.
  • Real estate: Mortgages or deeds of trust are governed by recording statutes; mortgage priority frequently depends on the recording date.

Real‑world examples

  • Equipment loan: A manufacturer borrows to buy production equipment. The lender takes an equipment security interest, files a UCC‑1, and, if the borrower defaults, repossesses and resells the machines to recover principal.
  • Inventory financing: A lender advances funds against inventory. Because inventory turns and depreciates quickly, the lender typically requires frequent reporting, borrowing base calculations, and may take additional collateral like accounts receivable.

Practical best practices (from lending experience)

  • Due diligence: Verify title, existing liens (UCC and real‑property records), and environmental or regulatory risks. In my practice, a simple UCC lien search frequently reveals prior encumbrances that change pricing or require intercreditor workarounds.
  • Clear drafting: Define collateral categories, include specific cross‑collateralization language only if intended, and state remedies upon default.
  • Perfection checklist: Match perfection method to collateral (record mortgage for land; file UCC‑1 for most personal property; obtain control for deposit accounts or certificated securities).
  • Ongoing monitoring: Require periodic appraisals, insurance certificates, and borrowing‑base statements for inventory and receivables.

Risks, common mistakes, and mitigation

  • Overvaluing collateral: Rely on conservative liquidation values (haircuts) not retail replacement values.
  • Poor descriptions: Vague collateral descriptions can result in unperfected liens or inability to repossess.
  • Multiple creditors: Intercreditor disputes occur if priorities aren’t documented; see our guide on Intercreditor Agreements to learn how lenders share collateral: Intercreditor Agreements: How Multiple Lenders Share Collateral.

Related topics and further reading

Tax and regulatory notes

Security interests and collateral sales can have tax reporting consequences for both borrowers and lenders; consult the IRS or a tax professional for specifics (https://www.irs.gov). Consumer lending also intersects with federal consumer protections—see CFPB guidance for consumer loans (https://www.consumerfinance.gov/).

Professional disclaimer

This entry is educational and not legal, tax, or investment advice. Lenders and borrowers should consult qualified counsel and tax advisers about drafting, perfection steps, and priority issues specific to their jurisdiction and transaction.

Authoritative sources