Lending a Hand or Getting Burned? The Crucial Role of Security in Promissory Notes

Let’s say a friend, family member, or even a business associate needs a loan. Perhaps they pitch it as a business investment. You’re willing to help / invest, and you’re smart enough to know that a simple handshake isn’t going to cut it. You’ve decided to use a promissory note – excellent choice! This legally binding document outlines the terms of the loan, including the principal amount, interest rate, repayment schedule, and consequences of default. But here’s where many people stop, and where you should take an extra crucial step: securing that loan.

Why You Want Security

Imagine you lend someone a significant amount of money with a promissory note. Everything goes smoothly for a while and payments stop. What do you do? Without security, your options are limited. You can sue them to get a judgment, but even a judgment doesn’t guarantee you’ll get your money back, especially if the borrower has no assets or income to seize.

Security is an asset or property the borrower pledges as collateral for the loan. If the borrower defaults, you have the right to take possession of that asset to satisfy the debt. This transforms your loan from a simple promise into a secured debt, significantly increasing your chances of repayment. It also gives the borrower a strong incentive to repay the loan, as they risk losing their valuable property.

How Security is Obtained

Obtaining security is all about documenting the borrower’s pledge of collateral. Common examples of collateral include real estate, vehicles, business assets, or even valuable possessions like jewelry, art, and other high-value items. For real estate, the security is established through a mortgage or deed of trust, which is a separate legal document recorded with the county. For personal property or business assets, security is granted by a security agreement that identifies the collateral, the debtor’s obligations to maintain it, and the secured party’s rights in the event of default.

What is a UCC-1 Financing Statement?

A UCC-1 Financing Statement, often just called a UCC statement, is a legal form that a creditor files to give public notice that they have a security interest in a borrower’s personal property. “UCC” stands for the Uniform Commercial Code, a set of laws that governs commercial transactions in the U.S.

The UCC-1 statement “perfects” your security interest, making it official and public. It contains basic information about the borrower, the lender, and a description of the collateral. In Washington, you file this document with the Department of Licensing.

Why You File a UCC-1 Statement

Filing a UCC-1 is a simple but critical step for two main reasons:

1. Priority: The UCC-1 statement establishes your priority in the collateral. If the borrower defaults and has multiple creditors, the one who filed their UCC-1 first generally has the first right to the collateral. This means if you file first, you get paid from the sale of the collateral before other creditors. Without a filed UCC statement, you may find yourself at the back of the line.
2. Public Notice: The filing creates a public record of your security interest. Anyone—including other potential lenders—can search the UCC database to see if a particular individual or business has already pledged assets as collateral. This transparency protects you from a borrower trying to use the same asset to secure multiple loans. It also protects other lenders from unknowingly lending against an asset that is already encumbered.

A Quick Word of Caution

While this blog post provides a general overview, securing a loan can be complex. It is always wise to consult with a legal professional to draft a promissory note and any related security agreements. A lawyer can help you properly identify the collateral, ensure all documents are correctly executed, and guide you through the process of filing a UCC-1 statement to protect your interests.

Lending money to someone you care about doesn’t have to be a leap of faith. By taking the time to understand and implement security, you’re not just protecting your money—you’re creating a clear, professional agreement that benefits both you and the borrower by setting clear expectations and consequences.

Let’s Talk.

Whether you’re facing a legal challenge or planning your next big move, Martin is here to help.

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