Cross collateralization is a process where a particular asset is used as collateral to secure two loans, an initial loan, in addition to a second loan. As with any asset pledged as collateral, if the borrower is unable to make scheduled payments on the loan, the loan is considered defaulted.
The lender can force liquidation of the collateral asset to recover their loan. However, the difference with cross collateralization is that the borrower must maintain payments on both loans that the asset is used as collateral.
Cross collateralization is a process where a particular asset is used as collateral to secure an initial loan, in addition to a second loan.
The loans that are collateralized can take on various different forms, such as mortgage loans, personal loans, auto loans, and credit card debt.
Cross collateralization can provide access to quick funding, without any need for additional capital raising.
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:
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.
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
A very simple example is if a homeowner who still ha a mortgage loan outstanding on their principal residence decided to make an investment into another property. They could potentially utilize cross collateralization, pledging each property as collateral for the loan.
From the lenders’ perspective, it is favorable since they have more security on their loan, given that they now have two assets to secure against the risk of loan default.
Furthermore, it slightly diversifies any property-specific risk at each of the individual properties. For example, if the crime rate in the neighborhood of the principal property increased significantly, it could decrease the value of the principal property, which poses a risk to the original mortgage loan. With the second property, such risks are mitigated.
From the borrowers’ perspective, they are more likely to get the loan on the investment property approved. Furthermore, since the overall risk to the lender has been reduced, the borrower may also receive a more favorable interest rate quote on their second loan.
Following up on the risks of cross collateralization, the borrower must ensure that they are able to make payments on both properties. For example, if the borrower is unable to service the loan on their investment property, the lender can pursue the value of their principal residence.
Thank you for reading CFI’s guide to Cross Collateralization. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful: