Using an asset like collateral for the first loan that in turn becomes a collateral for the second loan is basically what cross collateralization is. When the debtor fails to repay both of these loans within the set time period, the lenders have the right to liquidate the assets and make use of the funds generated as a result of repayment. From financing and mortgages to credit cards, cross collateralization could be used in many financial areas. Read more about buy and sell crypto instantly with Multibank.io
Let’s try to consider this for instance. You want to put in $400,000 for a property as an investment. To do so, at present you have:
- A $600,000-property
- $200,000 left on a mortgage with Lender X
- No deposit or cash
There is still a certain amount of equity for your house and so you could reach out to Lender X and get the complete sum of $400,000 that is required to purchase that property. Once the transaction is complete and you acquire the property, you would have $1 million worth of property in your possession along with $600,000 worth of debt. To add to that, if you consider roughly an 80% loan-to-value ratio, you would also have a minimum of $200,000 of equity in total for both your properties.
When you want to use the equity to buy another property as an investment, you could always go back to the same lender seeking yet another loan. However, you will have to bear in mind that your situation and circumstances as well as your lender’s policies at the time, your application for another loan may get rejected. You may be wondering why that should be a problem. There are enough lenders in the market and you could go to anyone. Well, the truth is, things are not so simple.
Say you reach out to Lender Y to secure a loan but how would you pay the mortgage security when Lender X has the first mortgage security for both your properties.
The better alternative in the scenario would have been to reach out to Lender X seeking a home equity loan for $280,000 if you have good credit that is and then service the loan. In this case, approval should not be a problem at all. Then you could use the $80,000 from that initial loan as a security deposit and reach out to Lender Y for the remaining $320,000 required to buy the new property. In this arrangement, you will still have $1 million worth of property but now both your lenders control only one of the two properties in your possession. You will also be left with an additional $200,000 on your home equity loan to buy more properties.
The downside of this cross-collateralization is that when you want to sell a property, it ends up changing the terms of your contract with the lenders. You essentially take away the security from your lender as you sell a property which alters your loan-to-value ratio.
Risks involved
The clauses in cross-collateralization are easy to overlook which is detrimental as you may then not fully understand the various ways through which you might end up losing your property. It is very common for financial institutions to cross collateralize properties, each time a client uses a loan and backs it from another financing from the very same bank. However, this is more prevalent when these transactions are within a single entity i.e the bank. If that property has been used to get financing from another institution, this becomes cumbersome and is thus avoided.
So say when consumers manage to get the financing for a vehicle purchase from a credit union, they might have to give their consent and sign a loan agreement where the collateral is the vehicle itself. However, it is possible that the consumer is entirely in the dark about the fact that the loan agreement may allow the vehicle to be a collateral for other loans or credits they could take with the union. The lien on the car from the first loan would get automatically applied to the various financing accounts the same consumer operates from that very institution.
This is a tricky business as one may end up losing the car that they’re still repaying loans if they fail to pay bills of the credit card on time if the card has been issued by the same credit union.
Benefits involved
With cross-collateralization, investors get the option to leverage their existing assets, invest in equity, and perhaps even finance a number of deals in one go. They could even choose to rapidly move on a risky property without having to get new funds or collateral. The pre-existing assets would do the job. Cross-collateralization is also a great option to finance assets for those investors who do not have sufficient credit and their loan request may not be accepted in all cases. It is also likely that cross collateral loans may offer better interest rates as the borrowers trade their assets for a loan.
Cross Collateralization and Bankruptcy
There may be some consumers who go bankrupt at the time parts of their property are caught up in cross-collateralization. They could try to get into some reaffirmation agreements for all the financing that has been/can be received by that collateral. They may then carry on repaying for those loans so they could retain ownership of the property.
The consumer may also opt to allow the collateral to be repossessed. The debts associated with the collateral would be released when the bankruptcy ends but then they lose the possession of the property. Also read cryptocurrency exchange 2022
Alternatives to a cross-collateral loan
Cross-collateralized loans offer low-interest rates and it is easy to feel tempted but if you want to avoid putting aside an asset as collateral for numerous loans, you could look at some options such as:
- Try to have a better credit score
- Find a cosigner on your personal loan, auto loan, or mortgage
- Save a lump sum for a larger down payment
- Check out down payment assistance programs
You could always try and negotiate to get a lower interest rate. As per a recent survey, a good 81% of borrowers were able to get a better deal by simply asking for it. You should look around and zero down on the best possible rate. It helps to have multiple options to choose from so you can rest assured that you have cracked a good deal.
