What Is a Cross-Collateral Loan?
It's common knowledge that if you don't pay your mortgage, the mortgage lender has the right to foreclose on the property in order to recoup their money. This is the basic idea behind cross- collateral loans, or cross-collateralization. In this article, we'll take a closer look at what this term means, where you're likely to encounter it in practice, and the pros and cons of cross-collateralization for borrowers and lenders. The simple definition is a cross-collateral loan (also simply referred to as cross-collateralization) refers to the practice of assets represented by one loan being used to simultaneously secure another loan. For example, let's say you have an auto loan and a mortgage, both held by the same lender. A cross-collateralization clause would mean that if you stopped making your payments on the mortgage, the lender could choose to go after the car, or vice versa. It's important to note that cross-collateralization doesn't just have to do with loans. Let's say you have a certificate of deposit (CD) account and an auto loan with the same financial institution. If you stop paying your auto loan, the bank could choose to withdraw from or freeze access to your CD until your loan is made current. The same could be said if you have a credit card at the same bank where you have a loan account. In practice, the most common place you'll find cross-collateralization is at credit unions. Credit unions are well known for offering favorable loan terms to borrowers -- and reducing their potential loss exposure through cross-collateralization is one way they're able to do it. In real estate situations, cross-collateralization is most common in construction loans, which are generally seen as risker to lenders than simple purchase mortgages. (After all, there's quite a bit that can go wrong with new construction, and budgets are forced to be stretched all the time.) So, if you're an investor who owns multiple rental properties, and you apply for construction financing, don't be surprised if the lender asks you to pledge at least one of your other properties as collateral. From a lender's perspective, cross-collateralization is viewed as a way to reduce risk. Think of it this way: A car loan is generally a riskier form of debt to a financial institution than a home loan, as it's backed by an asset (a car) that will likely lose value over time. This is why an auto loan generally comes with a higher interest rate than a home loan. On the other hand, if the lender knows it has the ability to go after the borrower's home if they stop making their car loan payments, the loan represents much less of a financial risk to the bank, and it can offer lower interest rates to borrowers than they otherwise would. From the borrower's perspective, cross-collateralization can be a positive and negative factor at the same time. As I just mentioned, a cross-collateralized loan may have a lower interest rate than if it were a stand-alone loan obligation, which makes the cost of borrowing lower. On the other hand, it can present an inconvenient problem if the borrower wants to sell an asset. Borrowers can generally avoid cross-collateral loans by using different lenders for different loans. And not all lenders implement this practice. But it's important to know if you're entering a cross-collateralization agreement before you sign a promissory note with any lender. The Millionacres bottom line  For property investors, cross-collateralization can be especially important to know about (and avoid) because many property investors have several different properties that could be used to cross-collateralize their obligations. If an investor wanted to sell one property that is used to cross-collateralize another obligation, the lender could potentially step in and block the sale.