Secured Credit 101: Priority of Liens

More than one creditor might have a claim to a security interest in collateral, especially valuable collateral. The most common example is a second mortgage or a home equity line of credit, when the homeowner has pledged the house as collateral, despite the fact a first mortgage exists. Just as the idea with one-lien collateral is that sale of the collateral provides an alternative source of payment for a loan, when there are multiple liens the idea is the sale of the collateral could in theory pay all of the loans. How does the law decide which creditor has greater rights? The law of secured transactions handles this with the concept of priority.

Priority, as it relates to security interests in collateral, is not the same as the bankruptcy concept of a priority claim. A priority claim arises when a particular type of creditor or debt is given first-dibs on distributions from the bankruptcy estate by the bankruptcy code. Child support and most taxes are examples of priority claims which have a priority of payment in bankruptcy.

Basics of Priority: Perfection

In a prior post in this series, I discussed how a secured creditor perfects a security interest. This perfection step, which might be a filing with register of deeds or Secretary of State, notation on a title, or even automatic on the grant of the security, is key to the rights of the creditor versus third parties. One such third party is another creditor with a claim of security in the same collateral.

The general rule is that first creditor to perfect their security interest has priority over the other. This can be modified by agreement ("subordination"), or sometimes the law might allow a later perfected lien to claim an earlier priority date of some significance to the nature of the lending. Additionally, some kinds of liens automatically have higher priority than others due to laws prioritizing their nature. An example would be a mechanic's lien having priority over a judgment lien.

Why does Priority Matter?

Priority matters to the borrower because it impacts the nature of the remedy available to the different creditors. One basic concept is that a sale of collateral by a junior lienholder leaves the more senior liens unaffected. On the other hand, a senior lienholder can wipe out the junior lienholders in much the same why it can wipe of the borrower's interest. This makes sale of the collateral much less attractive to a junior lienholder. For an example in a mortgage context, if a house has a $100,000 first mortgage associated with it, and a second mortgage holder forecloses, the purchaser at the foreclosure sale owns a house that still has a $100,000 mortgage attached to it. If the house cannot sell for $100,000, than no purchaser is likely to come forward.

In short, repossession and foreclosure are often less attractive to junior lienholders.

Security Interest Priority and Bankruptcy

Bankruptcy treatment of property with multiple security interests parallels the out-of-bankruptcy treatment of multiple security interests. The senior secured creditor has first grabs at the equity in the collateral. If there is enough equity left for the junior creditor after subtracting the balance due to the senior creditor, than that junior creditor is also a secured creditor. If not, they are either partially secured or wholly unsecured.

What a debtor in bankruptcy can do with a second lien varies depending on the type of collateral. For mortgages on the debtor's home, there are strict rules about when a second mortgage can be treated as an unsecured debt. For most other second liens, chapter 13 will allow pay-off at the equity over the first lien. In some cases, it may be an option in chapter 7 to redeem the second lien on personal property by paying its secured value.