Imagine a scenario in which you are ready to sell your car, which you now own free and clear, only to be told by your lender that you cannot sell it until you pay off another unsecured loan you have with the same lender. In essence, you are being told by the lender that you are not through paying on your car and the title still belongs to the lender. This is the result of an obscure clause called cross-collateralization, which is used by lenders in certain lending situations. You may not have known about it unless you carefully dissected your contract to find it buried deep in the fine print. Even if it was explained to you by your lender, chances are it would be long forgotten by the time you were three or four years into your loan, which is why most borrowers are caught off guard.
What Is a Cross-Collateral Loan?
Cross-collateralization is a method used by lenders to use the collateral of one loan, such as a car, to secure another loan you have with the lender. While that may appear to be a reasonable precaution taken by the lender, borrowers often do not realize the amount of control the lender has over their finances when it is exercised. It can keep you from being able to sell your car if the lender wants you to keep it as collateral. Worse, if you fall behind on another unsecured loan, such as a credit card, the lender can repossess your car. If you file for Chapter 7 bankruptcy, you could be required to relinquish your car to the lender until your outstanding debts have been satisfied.
Credit Union Practices
While cross-collateral loans are commonly used in auto lending, these loans are much more prevalent with credit unions. Credit unions operate differently from banks in that they are owned by their members, so the clause is an added protection against loan losses that would be shared by the members. The appeal of credit unions has always been their willingness to extend more favorable loan terms, especially when you have an existing relationship with them. If you finance a car through a credit union or have a savings account with it, you are likely to receive offers for low-rate unsecured loans. This is because credit unions can secure these loans with the collateral from your auto loan or savings.
Credit unions are an attractive banking and lending alternative for a number of reasons, including lower banking and borrowing costs. The practice of cross-collateralization could be a disadvantage if you are unaware of potential impacts on your finances. If you are considering a loan from a credit union, it is important to take a few precautions. First, do not take out more than one loan at a time from a credit union. Second, do not establish a credit card account or a line of credit where you have an auto loan. Third, do not bank where you borrow; keep your checking account at a different institution. Finally, always read the fine print on any loan document.
Cross-Collateral Loans in Mortgage Lending
Cross-collateral loans are also used in mortgage lending, primarily with construction loans when a borrower owns multiple properties. For example, if a builder who owns more than two properties seeks financing for a new project, the lender may want to secure the new loan by placing a lien against one or more of the other properties. The lender becomes the senior lien holder on all of the properties, making them difficult to sell.
As with any form of lending, whether it is credit cards, installment loans, lines of credit or mortgages, the burden is always on the borrower to understand every aspect of the credit terms, which are written primarily to maximize the lender's revenues and protect it against losses.