What are the differences between "first charge" and "second charge" in crowdfunding in the UK?
In a nutshell?
Large loans are made on the basis that lenders take control of assets owned by borrowers when there is a problem with loan repayment. Crowdfunding and peer-to-peer platform lending to property developers is the same. It gives lenders rights over borrower assets in what is called a ‘charge' on the project being built, the land it sits on or other developer assets.
The sale of these can allow for full or partial recovery of principal and interest where there is a default on a loan. The lender for whom charge over assets is first created is called the holder of "first charge". Where a second loan is backed by the same assets on which a first charge already exists, the subsequent charge holder is called "second charge".
This comes into effect once the holder of the first charge has sold the assets and received their dues. The second charge holder is entitled to receive the residual value of assets once the first charge holder has been satisfied.
In traditional banking, large loans are made on the basis that the lender can assume control of assets owned by the borrower in the event that there is a serious problem with the repayment of the loan. Mortgages and business loans have been "backed" by assets like this for centuries.
Alternative finance and modern forms of lending – crowdfunding and peer-to-peer lending – are no different.
Where a crowdfunding platform specializes in lending to property developers as CrowdLords does, it is common for a developer to seek a crowdfunded loan where the lender is given rights over the property in question, the land or specified assets of the borrower. These rights are established in what is called a "charge".
These will often be a charge over the property project being built, the land it sits on, and/or other assets in the developer's portfolio. As a last result the sale of these assets may allow the lender to fully or partially recover principal and interest if the borrower defaults on the loan, obtained via the platform .
The lender for whom charge over the assets is first created is called the holder of "First Charge".
A charge can however be created against the same assets by more than one lender. For example, the same developer might seek a further crowdfunded loan because they have decided to make substantial changes to the project that will incur further cost. There might have been unexpected cost overruns. Or existing investors might want to exit for their own reasons and want to be replaced. It might simply be that the first charge lender is not willing to lend sufficient funds and that a second lender is required.
Where a second loan is sought and is backed by the same assets on which a first charge already exists, the subsequent charge holder is called the holder of "Second Charge".
This second charge has the same force of law as the first charge, but it only comes into effect once the first charge has been fully satisfied – i.e. the holder of the first charge has sold the assets and received their dues.
When the first charge holder disposes of the assets held in their favour in order to recover the borrower's dues, the second charge holder is entitled to receive the residual value of the assets if any are left once the first charge holder has been satisfied.
Second charge lending is therefore always considered a higher risk, as the money lent may not be fully covered by the sale of the assets under a first charge and/or the process to receive dues takes longer.
The result is that borrowers pay a premium for second charge lending – often offering higher returns than less risky first charge loans. A developer may also offer part ownership of the development as a part of the loan terms, giving lenders the chance to receive any capital gains made on eventual sale of the underlying project.
For examples of first and second charge loans see CrowdLords's current and recent investment opportunities here. Sign up to see details of the Fife development – a first charge loan with a 12% target return over six months. For a second charge, sign up to see the Stockport loan at 16% target interest over eight months.
As always, the trick is to diversify across different property development projects and other investment opportunities, all with different tenures and different risk profiles, in order to mitigate overall portfolio risk. The ability to diversify your portfolio and reduce risk is seen as one of the main advantages of using property crowdfunding platforms like CrowdLords. Always be aware that your capital is at risk, returns are not guaranteed and investments are not covered by the Financial Services Compensation Scheme (FSCS). It is important to note that investors will only receive a return if the Company has sufficient assets to realise in the event of default and you may not receive the return of all of the sums you have invested.
For further details on managing risk on property lending investments, sign up here and be first to receive the forthcoming 2019 Guide To Managing Risk When Investing In Property.
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