What is a Floating Charge
A floating charge is a security, such as a mortgage or lien, that has an underlying asset or group of assets which is subject to change in quantity and value. When businesses use floating charges, it does not affect their ability to use the underlying asset as normal. Only if the company fails to repay the loan or goes into liquidation does the floating charge become "crystallized" or frozen into a fixed charge, and the lender becomes the first-in-line creditor to be able to draw against the underlying asset.
BREAKING DOWN Floating Charge
Floating charge securities allow business owners to access capital secured with dynamic or circulating assets. For retailers or others in product-based industries, these securities can provide an effective way to obtain funding using their inventories as collateral without interrupting their business operations.
Difference Between a Fixed and Floating Charge
Floating charges exist in contrast to fixed charges, which correlate with fixed assets. Fixed charge securities can be tied to tangible assets, such as buildings or equipment, as well as intangible assets, such as trademarks or patents. Essentially, a fixed charge is a security tied to a specific asset. For example, if a company takes out a mortgage on a building, the mortgage is a fixed charge, and the business cannot sell, transfer or dispose of the underlying asset (the building) until it repays the loan or meets other conditions outlined in the mortgage contract.
Floating charges, in contrast, relate to the current assets of a company, which are subject to change. These securities are tied to an asset, which the borrower may dispose of, sell or transfer in the normal course of business. To illustrate, imagine a business takes out a loan and secures it with its inventory. Although the inventory is collateral on the loan, the borrower can still sell and deal with it as usual. As the borrower sells, restocks and changes his inventory, it shifts or floats in value, thus the phrase floating charge. However, if the borrower defaults on repayments, the floating charge security crystallizes into a fixed charge security.
Crystallization of Floating Charge Securities
Crystallization is the process by which a floating charge security converts into a fixed charge security. In addition to cases of borrower default on repayments, crystallization also occurs if the company ends operations or if the borrower and lender go to court and the court appoints a receiver. Once crystallized, the now-fixed rate security cannot be sold, and the lender may take possession of it. Essentially, upon crystallization, the asset underlying the security can no longer float in value; it must crystallize to reduce risk for the lender.