What is Cross Collateralization & How Does This Loan Work?
- January 13, 2021
- 6 min read
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It can be tough to get high-quality loans with excellent interest rates, favorable terms, and more, particularly if you don’t have a great credit score at the moment. In order to get better loans, many individuals will either intentionally or unintentionally utilize cross collateralization, effectively guaranteeing one loan with the collateral from another loan.
While this practice has its benefits and potential advantages, it’s also a bit risky. In fact, it can lead to serious credit score problems or the repossession of personal assets – even assets that are already paid off – if you aren’t careful.
With all these risks, let’s break down what exactly cross collateralization is and how cross collateral loans work.
At its core, cross collateralization is an act where you use an asset (or assets) that is already the collateral for an initial loan as collateral again for a second loan.
It’s not uncommon for various loans to take collateral. Put simply, collateral is usually physical assets (though it can also sometimes be cash) that stand in as a loan guarantee. If a loan’s debtor can’t make scheduled repayments at the correct time, lenders can either take hold of the collateral assets or force the liquidation of the assets in order to be repaid.
Therefore, cross collateralization means using initial collateral for one loan to act as collateral for a second loan at the same time. As you might expect, this can be a little risky.
Now let’s break down cross collateralization loans. The best way to understand these loans is through an example.
Say that you’re trying to sell your car. But you are informed by your car loan lender that you can’t sell it unless you pay off an additional unsecured loan currently in your name. This may apply even if you have paid off your car since the car title may still belong to the lender themselves.
You might be surprised in such a case because the lender enacted a cross collateralization loan automatically without your approval. You can’t sell your car because the car acts as collateral for the second unsecured loan mentioned above.
Typically, cross collateral loans are used to secure additional loans if the borrower in question doesn’t have the creditworthiness or assets necessary to qualify for a second loan outright. Many borrowers initially believe this to be a reasonable precaution that lenders are well within their rights to take.
But as you can see in the above example, it can lead to sudden and unexpected control over your finances by your lender. This makes these loans risky for big amounts, such as business loans or car loans.
Any cross collateral loans involve collateral to guarantee loan value. All it requires is that some piece of collateral or some amount of assets are invoked as collateral for a secondary loan when they are already collateral for (or the main subject of) a primary loan.
One good example is second mortgages. Lots of people take out second mortgages on their property, which is technically a form of cross collateralization (since they may often use their home’s current equity as collateral, even if they are still paying the home off).
Cross collateral loans don’t have to use the same type of asset against one another. For instance, some lenders may use borrowers’ vehicles as collateral for different assets, even without telling the borrower themselves. In such a case, the borrower may be engaging in cross collateralization since their car (which they don’t own) is being used as collateral for a new loan.
Cross collateralization is a common practice with credit unions and auto loan lenders.
Credit unions are distinct institutions from banks, as credit unions must be owned by their members collectively. Thus, credit unions use cross collateral loans to protect against various losses that might harm the overall owner group.
This is also particularly common since credit unions often have more favorable loan terms compared to big banks or other financial institutions. Many credit union members may engage in cross collateral loans due to those favorable terms.
For instance, borrowers who finance their cars through a credit union may then take out a low rate unsecured loan quite easily. That’s because the credit union can simply secure the loan with the existing collateral from the car loan.
One of the biggest issues with cross collateral loans is the unexpected repossession of borrower property or assets when they weren’t aware of the loan in the first place.
Remember the example at the beginning of this guide. In that example, the borrower’s car acted as collateral for a second unsecured loan. The car was already paid off but the title still belonged to the lender since the second unsecured loan was not yet paid off.
If the borrower were to fail to pay the second unsecured loan off, the lender could then take the car via repossession and liquidate it in order to pay off the loan’s remainder. This would occur even though the borrower had technically paid off the car entirely.
Thus, if a borrower defaults on any cross collateral loan, they can expect any of the collateral assets in their first loan to be repossessed by the lender of the second loan.
Ultimately, this illustrates why it’s important for borrowers to read the fine print of any financial agreement they sign. It’s also a good idea to ask specifically whether your bank or credit union intends to start a cross collateral loan.
Many banks will default to cross collateral loans in order to keep loans “in-house” and since they prefer to make more money from existing members.
Lenders don’t use cross collateral loans out of spite. There are some advantages to this lending model:
- Many borrowers can qualify for higher loan limits by using existing collateral, even if that collateral is part of another loan. Thus, cross collateralization sometimes allows you to qualify for business loans or other loans that you otherwise wouldn’t, helping you to get out of a tight financial spot.
- Borrowers can fund multiple properties or projects with a single loan by using cross collateralization to essentially guarantee multiple loans against one another. Note that this is inherently risky since, if a single loan defaults, the others will also be at risk of defaulting depending on how the loan structure is set up.
- Borrowers will often be approved for riskier transactions if they have a lot of collateral on hand that they can use to guarantee a win for the lender.
However, cross collateral loans also come with several hazards and potential risks. Here’s a breakdown:
- As mentioned, it’s easy to lose one or all of your assets tied up in various loans if you try to take out multiple risky cross collateral loans at the same time
- Borrowers can all too easily become indebted to creditors if they aren’t careful, even after they finish paying off an existing loan
- Assets that are already paid off may nonetheless be repossessed by a lender if they act as collateral for a second loan that a borrower fails to pay back
- Since multiple loans can easily default if a borrower misses a single payment with one, the borrower’s credit score could drop significantly in an extremely short timeframe
Like all financial tools and loan types, cross collateral loans can be effective when used correctly and safely. However, it is usually smarter to avoid using cross collateral loans unless absolutely necessary.
This prevents you from accidentally risking paid off assets with loans that you may not be able to pay back. Furthermore, it prevents you from accidentally tanking your credit score if you default on multiple loans simultaneously just by failing to make a single payment.
The above risks are especially prevalent for business owners or individuals with lots of high-priced capital, such as house flippers who own multiple houses at the same time.
In the end, cross collateralization is a lending concept that far too few people are fully aware of. As a result, more people are likely involved in cross collateral loans than you might think.
It may be a good idea to take a look at your existing loan contracts and see if there is any cross collateralization going on at the moment that you may not know about.
Contact Seek Capital for additional financial advice and to find more information about high-quality business loans and personal credit options without cross collateralization. Don’t hesitate to give us a shout and we’ll be happy to help!
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