What is a purchase money security interest (PMSI)?
A purchase money security interest (PMSI) creates a security interest in goods that are acquired with the funds provided by the lender. This type of security interest provides special rights and preferences to the lenders who extend funding for the acquisition of the assets. Nevertheless, knowledge on how PMSIs operate is relevant for lenders and borrowers involved in the arrangements of such forms of secured financing.
How a PMSI Works
A PMSI is created when a lender advances funds for a borrower to acquire an asset and the asset itself is used as collateral. For example:
A person takes a loan from a bank to buy stock for the purpose of the business. The inventory is used as a security for the borrowed amount of money.
A business secures a loan from an investor for the purchase of new equipment. The mode of security provided to obtain the loan is the equipment.
A person borrows money for the purchase of a car from the auto dealer. This security interest is with the dealer’s financing company.
In each of the cases, the security interest possessed by the lender is a PMSI since the funds advanced were utilized for the purchase of goods. A financial asset is used to obtain funding for an identical or similar financial asset.
Special Protections and Priority
PMSI can be understood as a kind of additional security for lenders apart from standard security interest which is created over assets owned by the debtor. In a PMSI, the lender’s interest is always priority regardless of the occurrence of sale of the collateral by the borrower. This “super priority” continues as long as the PMSI is perfected in accordance with the law of the particular state.
Also, in case of borrower’s bankruptcy, the properly perfected secured assets under PMSI are not considered as part of the bankruptcy estate. If other assets may remain in the bankruptcy court or may be sold out, PMSI collateral can be retrieved by a lender at the earliest.
Because of these considerations, most lenders prefer to take a PMSI over any other type of security interest where possible. PMSIs enable acquisition of secured financing and loans which are essential for large business acquisitions.