Cross Collateralization: Definition, Benefits and Risks
Cross-collateralization involves using one asset as collateral for multiple loans at the same time. While this financing arrangement may seem like a smart way to effectively leverage your assets, there are risks involved. Here’s what you need to know before getting started.
What is cross-collateralization?
Cross-collateralization is a financial arrangement that involves a single asset securing multiple loans at the same time. For example, it’s common for both a mortgage loan and a home equity loan to use the same property as a form of collateral.
It can be helpful to think of cross-collateralization loans as the inverse financial scenario of a blanket loan, where a single loan finances multiple properties.
That said, this type of arrangement isn’t just used for real estate loans. It’s also commonly seen in small business financing contracts. However, any type of secured loan, like an auto loan or personal loan, could have a cross-collateralization clause included in its loan agreement.
How cross-collateralization works
If you’re considering a cross-collateralization loan, the most important thing to understand is that each loan product using that asset as collateral will equally affect the asset.
Let’s say your home secures a mortgage and a home equity line of credit (HELOC). If you continue to make your payments on time, there should be no issue. On the other hand, if you default on your payments for either the mortgage or the HELOC, you’ll risk losing your home to foreclosure.
In this case, defaulting on one of the loans will trigger default on all the loans attached to your asset. Eventually, the asset will likely be liquidated so that each lender can recoup the money they’re owed.
What are the benefits and risks of cross-collateralization?
Now that you understand more about cross-collateralization and how it works, let’s take a closer look at some of its pros and cons.
Benefits of cross-collateralization
- Lower interest rate: Cross-collateralization loans typically offer lower interest rates, as they’re typically secured by a sizable asset.
- Ability to leverage assets: They allow borrowers to leverage their existing assets instead of coming up with new backing for each new loan product they plan to take out.
- Easy transaction: Not all financial institutions are created equal — but, typically, if you use the same lender to take out multiple loans, you may have a streamlined application and underwriting process.
Risks of cross-collateralization
- Repossession risk: As explained above, if you default on one cross-collateralization loan, it’ll trigger default on all the loans attached to that asset. Your asset will likely be repossessed and liquidated as a form of repayment.
- Limited lender choice: Often, lenders won’t agree to allow an asset to secure a loan if it already has a lien attached to it from another lender. You’ll likely have to work with your existing bank or credit union if you want to finance multiple loans while using the same asset as collateral.
Cross-collateralization and bankruptcy
If you need to file for bankruptcy and have one or more cross-collateralization loans, you’ll have two options for how to handle them.
- Enter into a reaffirmation agreement: In Chapter 7 bankruptcy, a reaffirmation agreement allows you to repay a portion of what you owe the lender in installments. In return, the lender agrees not to repossess the asset as long as you continue to make on-time payments.
- Liquidate your assets: The other option is for your lender to repossess and liquidate your assets as a form of repayment. In this case, your debt is discharged after the liquidation. However, you’ll no longer own that asset.
Considering homeownership? Here’s our guide on how to get a mortgage after bankruptcy.
Frequently asked questions
Banks and credit unions like cross-collateralization because these lending scenarios are less risky for them. In these scenarios, if you default on one loan, they have the option to repossess your asset and receive repayment for multiple financing products at once.
The most common examples of cross-collateralization loans are found in real estate. For example, a commercial loan or residential mortgage loan could be secured using a piece of real property. Over time, the owner may decide to take out a home equity product that uses the same property as collateral.
If you don’t want to put your asset at greater risk of repossession by using it as collateral for another loan, you avoid cross-collateralization by reading your loan documents very carefully. Look for any cross-collateralization clauses in the fine print and, if you find any, be sure to ask your lender about alternatives to a cross-collateralization loan.
If you work on improving your credit score, you may qualify for a better rate on a new loan. Alternatively, you could also ask a close friend or relative to become a cosigner for you.