Many real estate loans rely on collateral — secured assets that serve as valuable materials for a lender to take if a borrower defaults on a loan. Most secured loans involve collateral that only applies to those loans specifically. Some real estate agreements may utilize cross collateralization: the practice of using an asset as collateral for more than one loan at the same time, or using multiple assets to secure one loan.
Cross collateralization can open up a lot of useful financing doors for real estate investors, business owners, and more. But it can also be risky, and it’s important to know what you’re getting into if you sign a cross collateralization loan. Read on for more information.
Cross Collateralization Explained
In a nutshell, cross collateralization means using an asset that would normally be secured for one debt or loan as collateral for multiple loans at the same time; alternatively, it can also meaning using multiple assets to secure one loan.
For example, say that you sign a secured loan to get the financing you need to pay for a second property. But to get that loan, you must put up significant collateral, like your first house. The first house is already collateral for its own mortgage. Therefore, you use the equity built up in that property to act as collateral for your new loan for your second house.
Cross collateralization can feel wise and financially savvy to utilize. It can also be a bit tricky to do right, so you need to know how cross collateralization works.
How Does Cross Collateralization Work?
When the same asset serves as collateral for multiple loans, many lenders see the appeal. That’s because the default risk is lower, as the assets that qualify for cross collateralization are usually very valuable, such as a house.
That said, borrowers have to make sure that they comply with all the terms in a cross collateralization loan agreement. For example, if you sign three loans and use cross collateralization to qualify, you must ensure that you meet the terms and conditions of all three loans all the time.
If you default on even one of the loans, all of the other lenders can also claim that you have defaulted. The asset(s) you put up as collateral could then be liquidated and used to pay down your debts. In this way, using cross collateralization is more complex than using traditional secured loans with one collateral asset per loan.
If you have a good financial head on your shoulders, you may find that cross collateralization is actually simpler. It’s because you finance all the security for your loans through the same business assets. In some cases, you can think of cross collateralization as tying all of your loans together.
Why Is Cross Collateralization Used?
Cross collateralization is a financing technique utilized by lenders and borrowers for various purposes. The reasons for employing cross collateralization can be broadly categorized into three primary sections.
Reducing risk to the lender. By securing loans against multiple properties, lenders minimize their exposure to potential losses in case of default. This collateral diversification helps distribute the risk associated with the borrower's repayment capacity and strengthens the lender's position in the event of foreclosure.
Allowing borrowers to qualify for larger loans or better terms. By offering additional properties as collateral, borrowers demonstrate a higher level of commitment and provide increased security to the lender. Consequently, this enhanced security may lead to more favorable interest rates, more extended repayment periods, or higher loan-to-value ratios, making the loan more attractive and accessible for the borrower.
Allowing borrowers to use their existing equity to fund a new acquisition. By utilizing the accumulated equity as collateral, borrowers can access funds without having to sell their existing assets, thereby facilitating the growth of their investment portfolio. This approach enables borrowers to maximize the value of their existing assets while simultaneously expanding their real estate holdings.
Examples of Cross Collateralization in Real Estate
Let’s take a look at some examples of how cross collateralization is used in real estate.
Securing Multiple Loans with the Same Property
For starters, you can use cross collateralization to secure multiple loans using the same collateral property.
As an example, you may have a primary residence. You’ve been paying down the loan for that home for 20 years, so you have built up significant equity in the house. However, you want to purchase a second home.
To do that, you pledge the equity that you've built up in your house to serve as collateral for the second mortgage. Technically speaking, your home is now cross collateralized; it is already pledged as collateral for the primary mortgage that you are still paying off. Now, it is going to serve as collateral for your second mortgage as well.
Using Multiple Properties to Cover One or More Loans
You can also use cross collateralization in real estate by leveraging multiple properties to cover one or more loans. This is useful in cases where one property may not have enough value to secure the loan you need (such as a high-value business loan).
This is often used with blanket mortgages: mortgage loans that cover the costs of multiple properties simultaneously. If you use the same lender for several real estate loans in order to finance multiple deals, you can use several properties to cover all the new loans you wish to take out (or the blanket loan, if you prefer to think of it that way).
Either way, you choose to think of it, your pledged collateral properties secure all the new loans you take out. If you default on one of them, all of the collateral properties will potentially be on the hook for liquidation and debt repayment.
Note, of course, that cross collateralization loans with lower interest rates and favorable cross collateralization clauses are only available if you have a good credit score and other good financial aspects.
Benefits of Cross Collateralization in Real Estate
Using cross collateralization in real estate could be a wise idea, as there are many advantages you can leverage with most lenders if you wish to sell one of the properties tied to the loan. The lender will usually set a release price that will allow the property to be sold or refinanced while keeping the mortgage on the remaining collateral.
For example, with cross collateralization, you can leverage any existing equity you have in your property(s), thus minimizing the capital requirements you need to secure new loans or properties. This can be advantageous if you don’t have a lot of cash saved up or other existing assets you can sell to qualify for a new loan.
Furthermore, cross collateralization is typically very appealing to lenders. It enhances your credit appeal, as lenders know that they'll be able to recoup their losses using the collateral you have pledged if you ever default on the cross collateralized loan in question.
On top of that, cross collateralization is relatively quick and simple in terms of funding. It usually incurs low fees, particularly when you involve one lender for multiple loans (as in the above-mentioned blanket loan example).
Lastly, you may benefit from favorable interest rates. Suppose your existing collateral is much more attractive than the new collateral associated with your new loan(s). In that case, you could get one or more new loans with very low, affordable interest rates. If you have planned out your finances properly, you’ll minimize the risk of defaulting on any of the new loans.
Potential Downsides of Cross Collateralization in Real Estate
It’s important to keep the potential cons of cross collateralization in mind as well, which increase in the event of default on any loan in the cross collateralization agreement.
For starters, cross collateralization means that you increase your leverage overall. You as the borrower have to service your new debt and ensure that you don't default on any of the loans you take out. If you default on one of them, the other lenders could count that as defaulting on their loans as well. The entire proverbial house of cards could come crashing down if you miss a single monthly payment.
In keeping with the above, this means that your risk of losing an asset is elevated if you default on any loans. Since there's increased risk involved with cross collateralization, you have a restricted ability to dispose of any pledged assets. In a big way, cross collateralization minimizes the financial options and flexibility you have once you sign the contracts.
Therefore, it’s only a good idea to participate in cross collateralization if you have a strong understanding of your finances and believe that you are in no shape to default on any of your loans. Cross collateralization is not wise if there’s a risk of defaulting on your loan or if you believe that your collateral assets may be vulnerable to being taken.
Contact Vaster Today
Cross collateralization could be an excellent way to use your equity to fund a new investment. When leveraged properly, cross collateralization may allow you to expand your investment efforts and purchase more than one property, especially if you have already built up sufficient equity in a primary property.
Vaster can help meet your lending needs. Our experienced loan officers can assist with determining the perfect financing strategy – in addition to what collateral you should use. Contact us today to learn more about mortgage preapprovals.