Purchase Money Security Interest (PMSI)

What Is a Purchase Money Security Interest (PMSI)?

The term purchase money security interest (PMSI) refers to a legal claim that allows a lender to either repossess property financed with its loan or to demand repayment in cash if the borrower defaults. It gives the lender priority over claims made by other creditors. In simpler terms, a PSMI gives initial claims on property to entities that finance purchases made by a consumer or other debtor.

Understanding Purchase Money Security Interest

Lenders have several options to protect their financial interests in the event that debtors fail to live up to their financial obligations. Financial companies may be able to pursue consumers who stop making payments on their debts by sending them to collections, taking legal action, enforcing liens, or by taking out special interests such as purchase money security interests. This interest gives a specific lender a right to property or its full cash value before any other creditor — as long as that lender's money was used to finance the purchase.

A PMSI is used by some commercial lenders and credit card issuers as well as by retailers who offer financing options. It effectively gives them collateral to confiscate if a borrower defaults on payment for a large purchase. It also is used in business-to-business (B2B) transactions. The option of obtaining a PMSI encourages companies to increase sales by directly financing new equipment or inventory purchases.

A purchase money security interest is valid in most jurisdictions once the buyer agrees to it in writing and the lender files a financing statement. The procedure is outlined in Article 9 of the Uniform Commercial Code (UCC) — the standardized business regulations adopted by most states. These regulations were adopted in order to make it easier for corporations to conduct business with others across state lines. Article 9 is the section of the code that outlines the treatment of secured transactions including how security interests are created and enforced.

The procedures permitting enforcement of a PMSI are strict and outlined in the Uniform Commercial Code.

The protection provided by a PMSI is one reason for the growth of point of sale financing, in which a retailer offers buyers direct financing for major purchases. If the purchaser defaults, the retailer may repossess the items purchased and may do so before any other creditors are satisfied.

Special Considerations

The rules regarding a lender's use of a PMSI are strict. These guidelines are outlined in the UCC. The lender must be able to prove that the goods seized were owned by the lender and were purchased using the lender's money. This is why lenders routinely pay vendors for goods directly before arranging for their sale on credit to a buyer. This establishes the lender's ownership of the goods in question.

For example, if a consumer arranged to buy a custom-made sofa on credit from a furniture retailer, the retailer would put through an order with the manufacturer and pay for the sofa before finalizing the financing agreement. In this case, the retailer is the owner selling the sofa — not the manufacturer. In legal terms, the retailer has a security interest in the property just sold and can obtain and enforce a PMSI.

For the same reason, if the buyer puts down a security deposit on the sofa, the retailer may insist that the buyer pays for it in full before the security deposit is returned. This establishes the full dollar value that the lender is entitled to demand in case of default. Court rulings regarding PMSI claims have established the lender's right to demand reimbursement of other costs related to the purchase such as freight charges and sales taxes.