What does a first charge mean?
You might to take out a loan for your business or for personal reasons. When doing so, there are numerous finance products available on the market that can give you the cash needed.
Lenders’ will generally require security to be used as a guarantee. One type of security is property, in which can be used as collateral for taking out a loan. In case a borrower cannot pay back the loan, the lender is entitled to repossess the asset used as security. This ensures the lender that in the worst-case scenario, a default, they can recoup the money that they lent out.
A lender typically wants to be in a low-risk position. Therefore, by requiring collateral, they are safeguarding their investment. At the end of the day, lenders’ make a profit from the interest they charge you. Losing money is a no-go, especially when some of these firms’ pool money from individuals to then loan out.
So, what gives a lender the right to an asset in the case of a default? This is done by registering a charge on the asset. A charge can be registered over property. A charge is only satisfied when the loan is paid off [1].
An asset can have several charges on it. If an asset you own has no charge against it, when you take out a loan, the lender will register a charge on the asset. This lender becomes the first charge, also referred to as the senior lender. If you then want to take out an additional loan from another lender, they can also take a charge on the property. However, as a first charge has already been registered, this new lender will sit at a second charge position, also referred to as a junior lender. They generally also need approval from the lender that holds the first charge, that a second charge position is acceptable.
The lender providing the first charge loan has the first claim on the property in the event of a default. The lender providing the second charge will receive payment after the first charge lender has been fully repaid. There can also be subsequent charges, with each being ranked in the order in which they were secured against the property.
Lenders can decide on the amount that they can loan out depending on the available ‘equity’. For example, if a house is worth £500,000, a lender might only be willing to lend you £400,000. This is also known as loan-to-value (LTV). The lender may only lend up to 80% of the value of the property because in the event of a default, they know that they can quickly recoup their money by selling the house at 20% less than the market value.
So, when does a second charge come in the mix? Usually, this happens when the first charge lender has a charge on the property at a low LTV percentage. For example, if you have a mortgage of £250,000 and your house is valued at £500,000, a second charge lender would be more inclined to give you a loan. Typically, these second charge finance products have a higher interest rate, due to the riskier position in comparison to the first charge lender.
The graph above illustrates a first and second charge on a house worth £500,000. Given the sizeable equity the owner has in the property, both lenders maintain a low-risk position. This enables the owner of the house to get the funding they need, giving adequate security for it.
References
[1] GOV UK. Registering a charge (mortgage) for a company. https://www.gov.uk/guidance/registering-a-charge-mortgage-for-a-company.