What is Cross Collateralization?
Cross collateralization is the act of using an asset that’s collateral for an initial loan as collateral for a second loan. If the debtor is unable to make either loan’s scheduled repayments on time, the affected lenders can eventually force the liquidation of the asset and use the proceeds for repayment.
Cross collateralization can be applied to various forms of financing, from mortgages to credit cards.
Cross collateralization involves using an asset that’s already collateral for one loan as collateral for a second loan.
The loans can be of the same type, as in a second mortgage, but cross collateralization also includes using an asset, such as a vehicle, to secure another sort of financing, such as a credit card.
Cross collateralization allows people to effectively leverage their existing assets, have a simpler loan process, and possibly get a better interest rate.
Cross collateralization clauses can easily be overlooked, leaving people unaware of the multiple ways they might lose their property.
How Cross Collateralization Works
Cross collateralization is the process of using an asset that is already being pledged as collateral to secure another loan. In their simplest form, cross-collateral loans involve using an asset to secure one loan while simultaneously securing another loan as well. Cross collateralization can be used against different types of loans, including, but not limited to:
- Mortgage loans
- Personal loans
- Commercial loans
- Credit card debt
However, cross collateralization is the most commonly used in real estate or other large assets, such as automobiles. For example, an individual with a mortgage loan on their principal residence can use their house as cross collateralization to secure a car loan. The lender for the car loan will likely be more comfortable with the borrower if they’ve pledged the value of their house as collateral. The process can be applied to various types of financing, such as credit cards or personal loans.
Is Cross-Collateralization Legal?
Cross collateralization is legal and fairly common, but a lender is required to inform you that cross-collateralization is occurring.
If you take out multiple secured loans from the same lender, like a bank, it might use the same collateral, making your assets cross-collateralized. You must legally consent to this, but do your due diligence in reading over any loan agreement. Be especially aware of “dragnet clauses” where a lender can pursue your asset if you used it for collateral for any loan with the lender.
“Lenders cannot use your business’s property as collateral without your consent,” writes Shawn Grimsley in the Houston Chronicle. “Lenders obtain your consent to cross-collateralization through a dragnet clause, which may allow the lender to use the collateral for any loans or other obligations your business may owe the lender.”
Is a Cross-Collateral Loan Right for Your Business?
Any kind of financing, from credit card debt to bank loans, comes with risk. As a responsible borrower, it is your job to understand the risks and rewards of the financing you qualify for before taking on the debt of an installment loan.
While a cross collateralization loan may save you money on interest, it can also jeopardize the assets you’ve worked hard to accumulate in the event of default.
Often, the better prepared you are, the better your odds of getting a loan. Business owners who know and understand their business credit scores, for example, are 41% more likely to be approved for a loan.
Nav can help you track your business credit and find financing offers that you’re more likely to qualify for. Sign up for a Nav account to start tracking your business credit scores and find your best business loan or business credit card options today.
The Risks of Cross Collateralization
Cross collateralization clauses can easily be overlooked, leaving people unaware of the multiple ways they might lose their property. Financial institutions often cross collateralize property if a customer takes out one of its loans and then follows up with other financing from that same bank.
(Though they’ll do this if everything stays in-house, there is a reluctance among banks to cross collateralize a piece of property that is already used to secure financing with another institution.)
For example, consumers who obtain financing from a credit union to purchase a vehicle might sign a loan agreement that uses the vehicle as collateral. What the consumer might not be aware of is that the loan agreement may stipulate that the vehicle will also be used as collateral to secure any other loans or credit they take out with that credit union. The lien that is placed on the car from the initial loan would then apply to all other financing accounts the consumer opens with that institution.
This situation could lead to an unfortunate circumstance in which a consumer who is late on paying a credit card bill—a card issued by the credit union—has their car repossessed, even though they are current on their car loan payments.
Is Cross Collateralization Worth It?
The answer to this question depends on your personal situation. Using your home’s equity to get a second mortgage is a common example of cross collateralization. This can be a good way to withdraw money from your property without having to sell it.
However, there are risks involved with cross collateralization. If you’re not careful about your payments, you may be forced to liquidate your home, vehicle, or other property to pay off one or both of your loans. You’ll also want to consider the cost of interest in any additional loans you take out.
Cross Collateralization and Bankruptcy
Consumers who file for bankruptcy while some of their property is tied up in cross collateralization might attempt to enter reaffirmation agreements for all the financing secured by that collateral. They would then continue to make payments on those loans in order to retain possession of the property.
Another option is to allow the collateral to be repossessed. The debts that were secured by that collateral would be discharged at the end of the bankruptcy, but the property would no longer be in their possession.
Benefits and Drawbacks of Cross Collateralization
Cross collateralization offers several benefits, including:
- Utilizing equity of existing assets to finance new ventures
- A source of funding in which new capital does not need to be raised
- Provides financing for those who with potentially poor credit quality by providing extra assurance to the lender
- A relatively quick source of funding that may achieve more favorable lending interest rates than otherwise
- Relatively simple to set up, especially if both loans are held by the same financial institution
- If both loans are held by the same financial institution, the process would likely minimize fees and transaction costs
While there are benefits, there are also risks and drawbacks that come with utilizing cross collateralization, including:
- Increasing the overall debt burden from taking on an additional loan. The borrower must now service two loans to ensure they do not default on either loan
- Raising the risk that the asset may be seized by the lender. For example, if an individual pledged their house as cross collateralization for an auto loan, and they missed an auto payment, they could potentially have their car repossessed by the lender
- Decreasing the flexibility of each asset. For example, an individual may not be able to freely sell one of the assets if it is pledged as collateral for another loan, even if they fully own the asset