Cross Collateralization Defintion, Risks and Benefits

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.

Key Takeaways

  • 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 common in real estate loans. For example, taking out a second mortgage on a property is considered a form of cross collateralization. In such a case, the property is used as collateral for the original mortgage. The second mortgage then taps into the equity that the property's owner has accrued for collateral.

There is a reverse circumstance wherein cross collateralization comes into play. Multiple real estate properties could be listed as collateral for one loan, which is typically the case for a blanket mortgage.

The loans involved in cross collateralization don't have to be the same type. Cross collateralization also includes using an asset, such as a vehicle, to secure various other sorts of financing or financing instruments, such as credit cards.

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.

Benefits of Cross Collateralization

Cross collateralization offers investors the opportunity to leverage their existing assets, tap into equity, and potentially finance multiple deals at once—or move quickly on a hot or high-risk property. You don't have to come up with new collateral or funds; you can use investments or assets you already have.

Cross collateralization can also provide financing for those who have less-than-brilliant credit or otherwise might not qualify for a loan. Cross collateral loans may also have better interest rates—because borrowers are essentially trading assets for a loan.

On a logistical level, cross-collateral loans are often easy to accomplish: The loan setup can be completed in one simple transaction, minimizing fees and costs. Depending on the financial institution and the type of loan, it's possible that the borrower will have to make only one monthly payment instead of multiple ones.

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.

What Is a Cross-Collateral Loan?

A cross-collateral loan is one in which assets that act as backing for one loan are used to simultaneously secure another loan. Typically, both loans are from the same financial institution, often a credit union.

How Does Collateral Work for a Loan?

Collateral is an asset—something of value—that works as security, or backing, for the amount you borrow. That is, if you default on your loan repayments, the lender can seize the collateral and sell it to recoup some or all of its losses. In short, the collateral acts as a form of protection for the lender against your not being able to repay the debt.

Why is Cross Collateralization Bad?

Cross collateralization isn't inherently bad, but it does carry some unique risks. It means that if you have a problem repaying one debt or obligation, the lender can tap into or seize the cross-collateralized asset—like taking funds from your checking account to pay a credit card bill. It can also tie up the resale of assets: For example, a lender might stop you from trading in your car, even though you own it free and clear because it's serving as collateral for another loan. Finally, cross-collateralization could negatively affect your ability to get new financing because so many of your assets have "strings attached" to them.

Article Sources
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  1. "Cross Collateralization: What Investors Should Know."

  2. Blue Fox Finance. "Cross Collateralization Explained."

  3. First Bridge Lending. "First Bridge Cross-Collateral Loans."

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