For creditors, there is one very important distinction that comes into play regarding how protected you are in the event of a default: are you a secured creditor or unsecured creditor.
If you’re a secured creditor, that means that you possess a lien on one of your debtor’s assets. If the situation ever arises where the debtor defaults on the payments they owe to you, you have the right to ask the court to seize the asset in question and permit you to sell it to recoup the amount you are owed (plus the cost of seizing and selling the asset). This power to foreclose upon and sell an asset provides an alternative form of payment to the creditor if the debtor has defaulted on its payment obligations. As a result, secured creditors are generally thought to be better protected than unsecured creditors. In exchange for this protection, secured debt typically is accompanied by lower interest rates to reflect the lower risk of missed repayment.
A common example of a secured creditor is a financial institution such as a bank, which may require collateral in the form of a car or a house if the bank is loaning funds related to those assets.
By contrast, if you’re an unsecured creditor, it means that you possess no lien on a particular asset of the debtor. Thus, you have no secondary recourse if the debtor does not repay you because you have no special right to foreclose on and sell a particular asset of the debtor. If the debtor refuses to pay back its debts, the only way for an unsecured creditor to get repaid is to sue the debtor in court and win. And if the debtor is bankrupt, the unsecured creditor is typically paid after the secured creditor. Because of the lack of alternative remedies for payment defaults, unsecured creditors are more at risk of loss than secured creditors. Accordingly, unsecured creditors typically charge a higher interest rate than secured creditors.
Two of the most common examples of unsecured creditors are credit card companies and landlords, as they often do not hold any of their debtors assets as collateral.
The Hybrid: An Undersecured Creditor
Sometimes a secured creditor’s lien (also called a security interest) is tied to an asset that is worth less than the amount of money owed to that creditor. For example, a creditor might be owed $100,00 and the only lien they have is on a beat-up 1982 Buick, worth $1000. Because the items underlying the lien are worth less than the amount of money owed, the creditor would not be fully repaid even if the creditor seized the Buick and resold it and kept the proceeds. The result is that the creditor is deemed to be “undersecured.” The first $1000 of the creditor’s claim against the debtor is deemed to be secured (by the $1000 Buick), however the remaining $99,000 of the creditor’s claim is deemed unsecured (unless the creditor makes a special, relatively uncommon 11 U.S.C. § 1111(b) election, which we will refrain from discussing here). The unsecured portion of the creditor’s claim is treated the same as other unsecured creditors.
Where Do You Fit In?
It might be possible that you have a secured claim and can qualify as a secured creditor. Proxifile and Enumero Law can help you figure this out. Tell us more here.