What Security Does a Second Charge Give Lenders?

Particularly if you use P2P lending companies where you can choose your own borrowers, you might be interested in lending to borrowers who are offer you a “second charge”.

This article is about what security this gives you as a lender.

We really try and avoid jargon at every opportunity, but there’s no way around it this time. You need to understand some words so check out our glossary of Peer-to-Peer Lending Definitions if you don’t have a basic understanding of the following words:

• First charge
• Secured loan
• Security
• Unsecured loan

Finished checking that out?

Our definitions in our glossary are very detailed and, I think, informative, so if you don’t mind I’ll copy the definition of second charge here now before moving on:

What is a second charge (and mezzanine finance)?

A secured loan can have a second charge. (Yes, and a third charge.)

This means that there is another, pre-existing loan secured against the same property. That other loan has priority (a first charge) if the borrower can't repay and the property needs to be repossessed and sold.

If you have lent money to a borrower with second charge security, you will only be able to recover your money after the lenders with a first charge have got all theirs, including the interest they are owed.

Mezzanine finance works pretty much the same way. This is when a borrower borrows, say, 50% of the property's value from some lenders, and then another 25% from other lenders.

The lenders who lent the first 50% get repaid first, including interest. Those who lent the next 25% – the mezzanine finance – get repaid last. In return for the extra risk, mezzanine lenders should expect to get higher interest rates.

A second secured debt could increase the risk of the borrower being unable to pay the first debt. So a first charge holder must normally agree before the borrower can get another charge.

It might do so if it thinks the secured loan will improve the borrower's finances, e.g. by keeping it afloat during a difficult time or because the loan will be used to improve the borrower's property and increase it's value. The first-charge lender could also simply accept a second charge because it sees no risk.

Second charges on P2P loans add a layer of complication in assessing the risk to lenders. The mere presence of a second charge can indicate higher risk.

What happens when a borrower stops paying a second charge?

The P2P lending company will attempt to recover the debt on your behalf. If necessary, it will repossess and sell the property.

However, the lender with a first charge will still get the first part of the proceeds. You will come next. If there’s enough money left after you get your share, other secured lenders will come next. The borrower will then get what’s left.

If the security is not worth enough, perhaps because it was overvalued, or its price is lower in a rapid sale, or its value has simply fallen, you might not get all of your money back.

When repossessing and selling security, there are also costs involved that could come out of your pocket if there isn’t enough money to cover them.

Your P2P lending company is not likely to repossess and sell the security if its value has fallen so far that you can expect to get nothing from it.

What happens if the borrower stops paying the first charge?

Borrowers usually stop paying second-charge loans first, but if it stops paying the first-charge holding lender, that lender is very likely to repossess and sell the property.

The result is exactly the same: you’ll get your share after the first-charge holder.