Cross Collateralization typically occurs when one asset is used as collateral for two or more loans. It also occurs when a borrower uses a group of assets to secure a group of seemingly unrelated loans. This commonly happens when someone has multiple loans at a single bank that uses the combined assets as collateral for all the loans.
1. Multiple Assets to Collateralize One or More Loans
One way that cross collateralization occurs is when two or more assets are used together to collateralize one or more loans. The easiest way to understand this is with real estate investment or construction loans where the borrower owns multiple properties. For example, a real estate investor can use a blanket mortgage to finance a multi-property deal.
However, this type of cross collateralization is also common for consumers or business owners. For example, if a person has a car loan, credit card, and unsecured personal loan at a single bank, the lender may cross collateralize all the loans together. This means that each of the individual assets are pooled together and pledged as collateral for all of the combined loans.
A business owner might have a small business credit card, line of credit, equipment loan, and commercial real estate mortgage at the same bank. Since there is the possibility of increased risk in this scenario, some banks will cross collateralize all the loans and underlying assets together. The result is that if you default on the equipment loan, for example, collateral for the commercial real estate mortgage can be seized by the lender as payment for the default.
The result for both the consumer as well as the business owner is that there is increased risk that assets may be lost in the case of a default. This is because the combined value of the underlying assets is used as collateral for each of the multiple loans. Further, since these assets are cross collateralized together, it becomes difficult to sell off a portion of the assets without dipping below the minimum collateral coverage ratio.
2. One Asset to Collateralize Two or More Loans
Using one asset to secure two loans creates a second lien on your existing asset. The most common example of this type of cross collateralization is when you take out a second mortgage on your home or investment property. This can be the case when an investor wants to unlock a property’s existing equity with a cash out refinance.
This can also be the case with two loans that aren’t both home-specific mortgages. For example, you could use your house as collateral for both a mortgage and a business loan. However, if you fail to make either your business loan or mortgage payments, the respective lender can either repossess your house or enforce liquidation of the asset.
Why Is Cross Collateralization Important?
Cross collateralization is important for many reasons. The first is that you can use an existing asset to secure multiple loans, giving you greater leverage and helping you unlock an asset’s equity. The second is that you can use multiple assets together to secure one or more loans, helping you get approved if you need a high loan amount or if you have poor or thin credit.
However, collateralization is also important to understand because it can put an individual consumer or business owner in a tough financial spot. For example, it’s important to know if a lender intends to cross collateralizes multiple loans together. If so, it’s possible that seemingly unrelated assets can be seized if one or more loans default. What’s more, it’s tough to sell off assets if they’re pooled together and used as collateral for multiple loans.
Pros and Cons of Using Cross Collateralization
Cross collateralization is helpful in many ways, but it can cause financial distress and isn’t for everyone. It is essential to understand the advantages and downsides of using this method to secure a loan or group of loans before you agree to it. To help, the following are few of the pros and cons of using cross collateralization:
Pros of Using Cross Collateralization:
- Cross-collateralization is useful for borrowers who can’t otherwise get approved for a loan.
- Borrowers can qualify for a larger loan amount if more assets are used as collateral.
- It can help people (like real estate investors) finance multiple assets together as one.
- Borrowers can unlock an existing asset’s equity with a second lien.
Cons of Using Cross-Collateralization:
- Borrowers may lose control of their assets because they’re used as collateral for multiple loans.
- For two assets securing one loan, borrowers can lose both assets if they default on their loan payment.
- For one asset securing two loans, borrowers might need to liquidate or foreclose if they stop paying either of the loans.
Cross collateralization commonly refers to the act of pledging two or more assets under one loan or using a single asset to secure multiple loans. It’s a good option for real estate investors, borrowers who need large loans, and those who cannot get approved for a loan due to bad credit. However, this kind of arrangement needs to be considered with caution since it can cause financial distress for consumers and business owners.