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Cross Collateralization: Definition, How It Works, Examples

If you’ve ever owned a house or a car, you’re likely familiar with collateralized loans. What this means is that your bank or lender essentially owns the asset—like your house or car—that you’ve pledged to secure your loan. If you default on your loan, the lender will seize and liquidate that asset to recoup the debt. Cross collateral loans do the same thing in practice but alongside an existing collateralized loan.

The lingo is commonly heard as a “second mortgage” or “putting up the car,” because that’s essentially what is happening: The lender uses an asset that’s already securing an existing loan to secure the new loan.  If your loan is cross collateralized, there will be a cross collateralization clause in the fine print of your loan agreement. This primer on cross collateralization can help you better understand the terms of your loan and the fine print before you sign on the dotted line is crucial.

What Is Cross Collateralization?

Cross collateralization is when a borrower uses an asset that’s already securing an existing loan to secure a new loan. It can also be when a pool of several assets is used to secure one or more loans. These loans are typically cheaper and easier to qualify for than other loan types. However, they come with greater risk, because if you default on any of your loans, you risk losing one or multiple assets.

How Cross Collateralization Works

A cross collateralized loan can appear in two ways:

  1. A single asset that’s securing an initial loan is used to secure an additional loan (or two): For example, one asset—like your home or your car—is backing multiple loans concurrently, like your mortgage and your small business loan.  As you pay down the outstanding balance on your property, you own it more and more each day. With more ownership of the item, the more bargaining power you have to put it against another cycle of debt.
  2. A pool of several assets can be used to secure one or more loans: Most often occurs when a borrower holds these loans with the same lender because that lender can aggregate the borrower’s assets to collateralize all of those loans in one fell swoop.

In practice, cross collateralization might mean that if you own multiple properties, then putting up all of those properties as collateral secures a single construction loan. Or, if you hold several types of loans with the same bank—say, a car loan, a business loan, and a mortgage—then the bank might aggregate your collateral to secure all of these loans combined.

Cross Collateralization vs. Collateralized Loans

There are two main ways of financing your small business: collateralized (or secured) or unsecured financing.

Unsecured financing allows business owners to access funding without having to put up an asset as collateral. The business itself is the holder of the loan and not a specific item of value.

Collateralized financing, in contrast, is always tied to an asset. The lender will seize and liquidate property, a piece of equipment, a host of inventory, or any other type of collateral (and there are many) if the borrower defaults on their payments. The amount of money that a lender extends is typically based in part on the value of that asset.

Cross Collateralization Examples

While cross collateralized loans aren’t common, they are useful. As we mentioned earlier, a blanket mortgage allows a real estate investor to cross collateralize multiple properties they own to secure financing to develop those properties.

A consumer can cross collateralize multiple assets towards one or multiple loans. For example, if you had a car loan, credit card debt, and a personal loan from the same bank, you could pool these assets together as combined collateral for all your debts. You could do the same thing if you had multiple business loans with the same bank (such as a business credit card, line of credit, and equipment loan). However, if you default on any of the loans, collateral from the others can be seized as repayment.

One of the most common examples of cross collateralization is when you take out a second mortgage on your home. Second mortgages allow you to use the existing equity in your home as collateral for other expenses. But beware: If you default on your second mortgage, you risk foreclosure on your home.

Pros and Cons of Cross Collateralization

Here are a few more pros and cons to consider about cross collateral loans:

Benefits of Cross Collateralization

1. Lower Cost

A secured loan is always going to be cheaper than an unsecured loan because you’re trading for it. Whether it be your house, your car, or your inventory, you’re relinquishing ownership of something of equal value to the loan, then buying it back over time through your loan payments.

When you look at quoted rates on a cross collateral loan, expect lower rates and longer terms than an unsecured loan. The more valuable the asset—and the more assets you pledge—the bigger the dollar sign you can expect to see in an approval.

2. Easier to Qualify

Lenders follow strict criteria when approving and rejecting loan applications. Factors include cash flow, business and personal credit scores, bank balances, industry, time in business, and more. With collateralized loans, so many of those stringent qualifiers fly out the window. As long as you have equity on hand, you can leverage that asset you’re more likely to secure the business financing you need.

3. Leverage Your Existing Assets

Essentially, cross collateralization allows for assets tied up in existing loans to become liquid again. In other words, just because one of your assets is collateralizing a loan doesn’t mean that the value of that asset has disappeared—with a cross collateral loan, you can leverage that value to secure multiple loans. This means your equity in assets can be turned into money once again.

Downsides of Cross Collateral Loans

1. Greater Risk

If you’re unable to repay your loan, the lender will seize your asset. This is the case for any secured loan, but the risk increases if you’re pledging multiple assets to secure a loan—you may lose not just one valuable asset, but several.

2. Less Favorable Terms

Depending on the contract you sign, there can be strenuous standards to meet throughout your loan payment period. Especially with a second collateralized loan, the criteria become more strict and the standards increase. That’s because a second lender may relinquish some rights in case of default if they take a second lien position behind the original loan. This forces them to offer less favorable terms than the first go-around.

3. May Affect Future Loan Decisions

When a bank or lender makes a financing decision, they carefully review the applying business’s credit score to determine credibility. But if you secure one (or several) loans with assets in your personal name, then you can’t place that debt on the business. Instead, you would personally assume the debt, add to your personal debt load, and hold yourself liable to the outstanding balance.

It’s incredibly risky to bank your own home, car, or another personal asset on your business’s finances. But if your business does meet your loan repayments responsibly, you’d be missing out on a bump in your business credit score, which could increase your chances of securing an even better business loan down the line.   

Should You Use a Cross Collateralized Loan for Your Business?

A cross collateral loan allows you to access equity you already own and turn it into liquid cash in the form of a loan. As you pay down your balance on that loan, you reclaim more and more of that asset, whether it’s your home or asset. Cross collateralization allows you to dip into that available balance to take out another loan.

However, cross collateral loans can be dangerous because you’re risking several of your most valuable possessions for several loans. You increase the chance of losing several assets, even if you default on just one of your loans.

So, the simple answer to “why use a cross collateral loan?” should be that you had no other option. Maybe you were looking for more money than your business had cash flow for, or perhaps some rates were outside your price range. Therefore, we always advise you to thoroughly understand the terms of your loan before risking your own assets. 

Even better—avoid that risk by seeking unsecured financing, or only securing your business loan with your business’s own assets. Work with a loan specialist to help you secure the most reputable loan possible.

The post Cross Collateralization: Definition, How It Works, Examples appeared first on Fundera Ledger.

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