Understanding first and second charge loans
First and second-charge loans are two different types of financing available for businesses. In our helpful guide, we’ll cover what a first-charge loan is, what a second-charge loan is, why they’re used, how they’re different, and finally, OakNorth’s approach to first-charge lending.
If you’re considering financing, you may have encountered some new terminology, like ‘first charge’. Unfamiliar words can often make your business loan application feel daunting and alien. So, to help you feel more confident and clued up, we’re laying down the basics for you in this article.
A ‘charge’ is a legal term used to describe the security that a lender has when it provides financing. The charge is made by the institution or individual lending the money against an asset or assets that belong to the borrower.
You may have heard of charges used with mortgages – that’s because when you take out a mortgage, the lender, typically a bank, places a charge on the property you’re buying. If you cannot repay your mortgage, the lender can create a ‘charging order’. This court order allows them to seize and sell your property to recuperate the lost funds.
In UK lending, charges are most commonly applied to land, property, or both as the security for a loan. But, as technology has rapidly advanced, we’ve seen a rise in successful businesses with non-physical assets – think ecommerce or software as a service.
And in a post-covid world, more and more companies are ditching their offices or downsizing to smaller serviced co-working spaces for increased flexibility. This means lenders need to get more creative with their securities looking at things like patents, intellectual property, trademarks and copyrights. Additionally, HMRC states that charges are also placed on financial products such as:
Charges are placed on assets, like property, to protect lenders, giving them security if there are defaults, or a business cannot repay its debt. But scaling businesses will usually have more than one loan or type of financing to help them operate and grow. In this scenario, you’d have lots of lenders looking to charge the same assets, and financers would scramble to take ownership to cover any losses if a company went bankrupt. Of course, this isn’t a logical solution, so that’s where priority comes into play.
Charges are ranked by priority of repayment. A first charge is the highest priority that a lender can have. So, if a business cannot repay, the lender with the first charge on a property will gain that asset as theirs. They’ll then sell it to retrieve as much money as they can.
A second charge usually means a different lender has provided a business with additional financing. Often the amount is lower than the first loan. If the security for the second loan is the same asset as the first loan, the other secondary lender will need to place a second charge on it. This puts them second in the repayment queue. If the business defaults, the first charge lender must regain all the money owed before the second lender can get paid back. For this reason, secondary loans are riskier for lenders and so come with higher interest rates for borrowers.
A developer needs to purchase some land to build 10 new homes. The land and properties they are building have been valued at £45m. A bank agrees to loan them £31.5m to put towards the project at a loan-to-value (LTV) ratio of 70%. They go ahead with this financing option, and the bank places a charge on the future properties and the land. At this moment, this bank becomes the senior lender, and its charge is the first priority.
The developer spots a deal on raw materials and wants to accelerate its purchase to save money in the long run. It needs a bridging loan to cover these short-term costs, so it approaches a different lender and apply for £2m. The second lender sees that the developer already has outstanding debt of £31.5m with a senior lender, and it has a first charge on the property. The assets would be sold if the developer couldn’t repay its debt. Only when the first lender had been paid back the £31.5m, plus any other fees or interest owed, would the second-charge lender receive its £2m.
First and second-charge loans have a few distinct differences. As a business owner, it’s essential to understand these to choose the right financing at the right time.
The most significant difference lies in the priority of repayment. First-charge loans have the highest priority. In the unfortunate event of a property sale due to default, the proceeds will go towards paying off the primary lender before addressing any other loans. The clue is in the name of second-charge loans; they’re second in priority for repayment, making it riskier for the lender.
As first-charge loans are considered less risky for lenders, they typically come with lower interest rates and more favourable terms. Second-charge loans, however, often carry higher interest rates to compensate for the increased risk that the lender takes on in a default event.
First-charge loans are usually larger, as they cover the primary purchase price of the property they’re secured against. Because second-charge loans are riskier and more expensive for businesses, they tend to be used as short-term bridging loans to supplement larger debt.
They’re often used for quite specific goals. For example, if a development has been delayed, it’s not uncommon for a borrower to take out a second-charge loan to access capital in the short term ahead of the sale. You can find more examples of second-charge lending for real estate in our complete guide to bridging loans.
Because second-charge loans are more expensive, they tend to be paid off faster to minimise the interest repayments. But, depending on what it’s being used for, the term time can span from a few weeks to a few years.
The application process for a first-charge and second-charge loan follows similar steps. For both, you’ll need to prove to any lenders that you have a strong business strategy, including detailed plans for how you’ll spend the money you’re borrowing. Risk teams will analyse your credit history and other business financials, such as your last five years’ accounts and your earnings before interest, taxes, depreciation and amortisation (EBITDA), to see whether you’re in a healthy position to take on debt.
As a second-charge lender takes second-place security for its loan, they’ll also conduct an equity assessment. This essentially means getting an updated valuation of your properties and subtracting the difference between the valuation amount and the first-charge loan amount. The difference between the two is the available equity you have to use as security for a second-charge loan.
So, in the example used above, if the value of land and properties is £45m, and there is a first-charge loan of £31.5m, there is £13.5m equity left in the assets that can be used for a second-charge loan.
It’s not unusual for businesses to have multiple loans at once. Usually, this is how they grow faster. By hiring more people, investing in more products, assets or stock, expanding into new markets, or accelerating research and development, capital is always needed upfront to drive revenue in the long term. Chief Financial Officers (CFOs) or accounting partners often advise different types of financing for different periods of a business’s life cycle.
Applying and securing senior debt is no small feat. It’s a big decision for any business, even if they’ve been through the process before. And as senior debt is for long-term business strategies, it’s a longer-term higher value investment that can only be paid back gradually once the money has materialised into positive outputs.
As far as second-charge loans go, an expensive cash injection is fine for the short term, but if used frequently, it will soon eat into your margins. They’re great for interim capital when waiting a few weeks or months for a big payout from a sale or invoice. That way, you don’t have to put the brakes on your plans, even if just for a few months.
Its cash flow fluctuates: Not all businesses have a predictable cash flow, so plugging the gap short term helps them operate efficiently, even when things are a bit slower.
It prioritises growth: Rapid growth requires constant time, effort, and money investment. It also means juggling more than one thing at once. Taking out debt to cover one project leaves you waiting for it to end before you can start the next. If you’re in a healthy position to do so, you can secure other types of financing to help you kick off the next one simultaneously.
It’s future-facing: Businesses that stand the test of time always think about the road ahead. There are certain things that businesses should invest in early to reap the benefits later on. One example is care home operators that invest in renovations and updates to their facilities before they get into a state of disrepair. Staying ahead of the curve gives them a competitive advantage and builds customer trust and brand loyalty.
OakNorth provides fast and flexible debt financing from £500k to tens of millions. We’re a senior first-charge lender that works closely with experienced management teams to build long-standing growth and capitalise on exciting market opportunities.
We’ve helped seasoned bar and restaurant owners dominate London’s social scene, nationally-loved gyms strengthen their offerings, and innovative property developers build new operationally net-zero homes.
We have a depth of experience working with mezzanine and second-charge lenders and can help our customers find the right solutions for their long-term strategy. Last year, we strengthened our relationship with ASK Partners to co-lend to more successful developers and investors across the UK.
If you’re looking for a trusted long-term financing partner that understands entrepreneurialism, get in touch today.