Purchase Money Security Interest (PMSI) Definition, How It Works

What Is a Purchase Money Security Interest (PMSI)?

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 if 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 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 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 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.

Purchase Money Security Interest Rules

PMSI rules vary based on the type of collateral obtained using loan proceeds. In general, the broadest rule is that PMSI is granted to the first creditor who filed a financing statement or "perfected" its security interest in the collateral.

Below are the specific rules for inventory and non-inventory collateral, although there are specific rules for other types of goods as well.

PMSI Rules: Inventory Collateral

Section 9-324(b) outlines the rules to perfect PMSI in inventory. First, the PMSI must be perfected when the borrower takes possession of the inventory. Second, the secured party must provide notification to conflicting security holders before perfection. Third, the secured party must notify other security holders that it expects to acquire a PMSI in the borrower's inventory.

To perfect a PMSI in inventory, the secured party must file a UCC-1 that identifies the goods sold as collateral. This filing provides notice to other interested parties that the secured party is in the process of obtaining a PMSI on the borrower's personal property. In addition, the written notice delivered to other security notices must be distributed no more than five years before the borrower receives inventory.

PMSI Rules: Non-Inventory Collateral

The rules for securing a PMSI for non-inventory collateral are often less rigid. The secured party must be able to demonstrate that the credit they extended to the borrower was used to purchase the collateral. The secured party must also file a financing statement covering the collateral within 20 days of the borrower receiving possession of the collateral.

Similar to inventory PMSIs, a secured party must file a UCC-1 to perfect a PMSI for non-inventory collateral. This must be filed before the borrower takes possession of the collateral or within the first 20 days of possession. If the filing takes place after these 20 days, the secured party won't have PMSI priority and will be prioritized after other perfected security interests.

Establishing Security Interest as the Seller

At the core of PMSI, the party attempting to gain the secured interest must demonstrate that the credit they extended was used to acquire the collateral. For this reason, a company may want to intentionally structure an order of payments or series of contracts for goods not yet manufactured.

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.

The Bottom Line

Creditors are often prioritized in terms of timing. The PMSI exception allows credits that may not be first in line to still get a secured interest in collateral. To gain this secured interest, the lender must be sure its loan funds were used to buy the goods, file a UCC-1, and follow other regulatory rules based on the type of collateral.