Financing property allows you to immediately enjoy the benefits of an asset in exchange for a promise to pay back the debt plus interest over time. However, the person or company extending the credit may insist on having certain protections in place in the event that you fail to pay, or file for bankruptcy. One type of protection commonly used in these instances is a purchase money security interest.
A purchase money security interest is an agreement between a seller and person or business buying property on credit. Specifically, the company allows you to take goods on a payment plan with the seller retaining the right to reclaim the items you purchased in the event that you fail to make payments. In other words, the items you receive are essentially used as collateral. An example might be buying a sofa on a store charge card or ordering a crane for your construction company through a building supplier. A PMSI agreement can be included in your application for the store card, or presented as a separate agreement. It is important to note the distinction between purchasing on credit with the seller and financing the items in other ways, like with your personal Visa card. In the latter case, you own full legal title to the property and the credit card company cannot reclaim it even if you default on the debt.
PMSIs provide good protection to the creditor because they "perfect" automatically without having to file or record any documents as with other types of debts. Perfection involves putting everyone on notice that the creditor has an interest or "lien" on the property you financed, which means the creditor has priority over any subsequent secured creditors that may come forward. An example would be if you used a guitar financed under a PMSI as collateral for a cash loan. Here, the holder of the PMSI would need to be paid in full before any other creditors could try to repossess the guitar.
Chapter 7 Bankruptcy
Having a PMSI becomes important should you file for bankruptcy. In a chapter 7 bankruptcy, a trustee is appointed to collect your assets and liquidate, or sell, them to pay back creditors in a specific order of priority. Debtors are typically allowed certain exemptions, such as keeping a certain amount of equity in their homes, so this limits the money available to pay creditors. Any outstanding debts that cannot be paid are then wiped away and the debtor gets a fresh start. Here, a creditor with a PMSI can be assured that he will at least get the financed goods back, which may be more than he would have received without the PMSI.
Chapter 13 Bankruptcy
The process is a bit different when you file for a chapter 13 bankruptcy rather than a chapter 7. With a chapter 13, your assets are not sold and instead, you are put on a court-approved payment plan to effectively pay back your debts over time. However, in most cases, a creditor with a PMSI is only entitled to receive the present value of the goods financed, and must allow a repayment period of 60 months. This is referred to as a "cram down," as it could significantly reduce the amount you end up paying under a PMSI, particularly if the goods have decreased in value and your existing debt to the company is high. Keep in mind that cram downs are not allowed if your goods were financed within one year prior of filing for bankruptcy.