When a business borrows money from a lender such as a bank or another financial institution, it is not unusual for the lender to ask for security for the debt.
That helps to protect the lender’s position as it can seize and sell the asset that has been given as security if the loan cannot be repaid.
The idea of providing security for a loan is a concept most business owners will be familiar with, after all, it’s something all homeowners do when arranging a mortgage. However, the confusion often comes with the two different types of charge, fixed and floating, that are used to give lenders security over the assets of a business.
In this quick guide, we’re going to explain what fixed and floating charges are and explore the differences between them so you’ll know what you’re signing up for.
What is a Fixed Charge?
If a debt is subject to a fixed charge, the borrowing will be secured against a substantial and identifiable physical asset such as land, property, vehicles, plant and machinery.
If the business is unable to keep to the terms of the finance agreement, the lender will take charge of the asset and look to sell it in order to recoup the money it is owed.
Fixed Charge Over Assets
When a lender has a fixed charge, it effectively has full control over the asset the charge applies to.
If the business wants to sell, transfer or dispose of the asset, it will have to get permission from the lender first or pay off the remaining debt.
It’s also important to note that a fixed charge gives the lender a higher position in the queue than a floating charge for the repayment of the debt in the event of the borrower’s insolvency.
In this type of arrangement, the finance provider buys a business’s outstanding invoices and lends money against them. The debtor book is then subject to a fixed charge, which means the business’s invoices effectively belong to the finance provider and not the company.
Examples of financial arrangements that are commonly subject to a fixed charge include:
- Bank loans
- Invoice factoring arrangements
What is a Floating Charge?
A floating charge applies to assets with a quantity and value that can change periodically, such as stock, debtors and moveable plant and machinery.
It gives the business much more freedom than a fixed charge because the business can sell, transfer or dispose of those assets without seeking approval from the lender or having to repay the debt first.
From the lender’s point of view, a floating charge leaves it more exposed than a fixed charge because the value of the assets can and will change over time.
However, it’s not possible to attach a fixed charge to every company asset, which is why floating charges are used.
Floating charges essentially ‘float’ above changing assets and only become fixed charges, a process known as ‘crystallisation’, in the following circumstances:
- The company defaults on the repayment and the lender takes action to recover the debt
- The company is about to be wound up
- The company appoints the receiver
- The company will cease to exist in the future
What is the Difference Between a Fixed and Floating charge?
There are a number of major differences you should be aware of:
- A fixed charge applies to a specific identifiable asset, while a floating charge is dynamic in nature and generally applies to the whole of the company’s property.
- An asset covered by a fixed charge cannot be sold or transferred unless the charge holder agrees. A floating charge can be sold, transferred or disposed of until a point when it crystallises and becomes fixed.
- A fixed charge is given preference over a floating charge in insolvency
Where do Fixed and Floating Charges Rank for Repayment in Insolvency?
If your business enters insolvency, there is a designated order that determines which creditors will be repaid from the sale of company assets first.
Both fixed charge and floating charge holders are classed as secured lenders.
That means they take priority over unsecured creditors who must wait until all other costs and creditors have been paid before they receive any of the money they are owed.
Fixed charge holders are first in line for repayment and receive the money they are owed from the sale of the asset they hold a fixed charge over.
Floating charge holders must wait until fixed charge holders, preferential creditors such as employees and the insolvency practitioner have received the money they are owed before they are repaid. By that point, there may not be enough funds to repay the debt in full.
Under the Insolvency Act 1986, the hierarchy for repayment in an insolvency situation is:
- The liquidator’s fees and expenses
- Secured creditors with a fixed charge
- Preferential creditors (typically employees with wage arrears)
- Secured creditors with a floating charge
- Unsecured creditors
Want to know more?
If you want to know more about fixed and floating charges, have been asked to provide security by a lender or want to know how a debt will be treated on insolvency, please get in touch with our team.
We can provide a no-obligation consultation to clarify your position.