Everyone knows that if you fail to pay your mortgage, the lender has a right to foreclose on a borrower’s property and recoup its money. As an example, if a borrower were unable to pay their mortgage, the lender could be able to repossess their car, withdraw funds from their bank account, or even charge their credit card.
Well, that’s cross-collateralization or a cross-collateral loan, in a nutshell.
In this article, we’ll take a closer look at cross-collateralization, what you can expect from a cross-collateral loan as well as the pros and cons of cross-collateralization for both borrowers and lenders.
What is a cross collateralization?
Cross collateralization refers to a lending method that uses the collateral of one loan to secure another loan with the same lender. For example, consider a case where a borrower has an auto loan and a mortgage held by the same lender. A cross-collateralization clause could mean that if the borrower stopped making their mortgage payments, the lender could choose to repossess the car or vice versa.
It is important to note that cross collateralization doesn’t necessarily require that you have two loans with the same lender. For example, suppose there is a savings account held with the same financial institution that manages an auto loan. In that case, a cross-collateralization clause could allow the lender to freeze or withdraw from the account if the borrower stops making loan payments. The same scenario could apply if the borrower has a credit card with the same financial institution.
Cross collateralization is popular among credit unions
Cross collateralization as a practice is most commonly used by credit unions, which are well known for offering favorable loan terms to borrowers. Cross collateralization reduces a lender’s potential loss exposure, so it is one way that credit unions can provide those good terms, especially to individuals who have an existing relationship with the lending institution.
When a borrower finances a vehicle with a credit union or has a savings account with the institution, they will likely receive offers for low-rate unsecured loans. That is because credit unions will typically secure those loans with collateral from an auto loan or savings account in the background within the terms of the agreement.
Credit unions are typically an attractive alternative to traditional lenders and financial institutions for several reasons, including lower banking fees and borrowing costs.
Cross collateralization is common in construction loans
Because lenders generally consider construction loans to be risker than traditional mortgages, they will employ cross collateralization. Suppose you are lending to an investor, for example, that owns multiple rental properties, and they apply for construction financing. In that case, the lender is likely to ask the borrower to pledge at least one of the investment properties as additional collateral for the loan. If the event of a default or a construction delay, the lender becomes the senior lien holder on all the properties, and has the opportunity to regain its investment through other collateral.
Cross-collateralization has its pros and cons, particularly for the borrower
There is no denying that cross collateralization reduces the risk for the lender.
From the lender’s perspective, a car loan is riskier than a home loan because the car will lose value over time. That is why auto loans generally have higher interest rates than home loans. However, if the lender can seize the borrower’s home should they stop making car payments, the loan risk has dramatically diminished. In turn, the lender can offer a lower interest rate.
From a borrower’s perspective, a cross-collateral loan may offer a lower interest rate. Still, it can cause headaches if a borrower decides to sell an asset backing the loan, for example. Not to mention that they could stand to lose assets backing the cross-collateral loan if they default on the loan. Not all lenders implement cross-collateralization in their loan agreements, and borrowers can avoid cross-collateral loans by doing business with different lenders.
Here’s your bottom line
When it comes to any form of lending and borrowing, regardless of whether it’s a credit card, installment loan, line of credit, or mortgage, make sure you understand every aspect of the loan terms or credit agreement.
It’s possible to write terms in a way that is meant to maximize the lender’s revenue and protect it against losses, and Geraci’s team of experts can help make sure you are covered.