Cross-collateralization benefits, risks, how it works & more

When you're looking to buy properties for your business, it's important to understand the different ways you can finance the purchase.

One method of finance is cross collateralization, which involves using the equity from one property to secure financing for another. This strategy can be a useful way to expand your investment portfolio.

This approach is often employed in commercial lending and can be a valuable tool for small and medium-sized businesses (SMBs) looking to maximize their borrowing potential.

However, it also comes with significant risks that businesses must carefully consider.

In this article, we’ll dive into what cross-collateralization is, how it functions, and the pros and cons of using this method.

But before considering it to fund your business, it’s crucial to grasp what collateral means. 

What is collateral?

Collateral refers to valuable assets that a lender might ask you to offer as a security measure when borrowing money. These assets can include cash, stocks, products, real estate, or other valuable items.

Unsecured loans don’t need collateral, but secured loans do. For instance, in a mortgage, the house serves as collateral. If you can't repay the loan, the lender can seize and sell the house to recover the money owed.

The collateral needed for secured business loans can differ among lenders. Some may require fixed assets owned by your business, while others might ask for personal assets.

Additionally, if you’re financing a big purchase like equipment, it may act as the collateral itself.

Other forms of collateral loans include car loans, where the vehicle is the collateral, or secured business credit cards, which are useful for those establishing a credit history.

There is another, somewhat more complex type, known as cross-collateralized loans.

What is cross-collateralization?

Cross-collateralization occurs when a borrower uses the same asset as security for more than one loan.

If the borrower defaults on any of the loans, the lenders involved can claim the asset, sell it, and use the proceeds to cover the outstanding debt.

This practice can be applied to different types of loans, such as mortgages or credit cards. It is important to note that cross-collateralization typically involves a single lender, which can increase risk compared to other lending methods.

Is debt financing the right funding choice for your business? Learn how it works.

What is cross default?

If the borrower fails to meet the terms of any loan secured by the asset, it could trigger a default on all associated loans. This is sometimes called a cross-default.

For example, property loans like mortgages or lines of credit, where the same property might secure multiple loans.

If there's a default on one loan, it could affect the others. This can also apply to other assets in business settings, where the same piece of equipment or inventory might secure multiple loans.

The borrower must keep up with all loan payments and other requirements for each loan that shares the same collateral.

If they don't, the lender might take action to seize and sell off the asset to recover the money owed on all the loans secured by it.

How does cross-collateralization work?

1. Pledging multiple assets

When you're looking to borrow money for your business, lenders first need to feel comfortable with the risk they're taking. They want to be sure you’ll pay back as promised.

To assess their risk, lenders might check your credit score, ask for a down payment, or require some form of collateral.

If your credit isn’t the best, or if a single asset isn’t enough to secure a loan, a lender might ask you to pledge multiple assets.

This can give the lender more security and reduce their risk. When you agree to this, the lender could register a blanket lien—which means they claim rights to those assets—through your local state office.

This is one way to set up cross-collateralization.

2. Using one asset for multiple loans: 

The second form of cross-collateralization happens when you use one asset to back several loans. This is common with second mortgages or home equity loans.

For example, the same vehicle that secures your car loan might also be used as collateral for a personal loan with the same lender.

Lenders are supposed to tell you if you need to pledge (or re-pledge) an asset for multiple loans.

Yet, sometimes borrowers find a cross-collateralization clause in their loan agreements.

That's why it's crucial to thoroughly review and understand your loan documents before signing.

Example of cross collateralization 

Let’s say you own a house that's worth $600,000, and you still owe $300,000 on it. This means you have $300,000 worth of equity in your home. Let’s find the LVR—loan-to-value ratio.

LVR = (Property Value / Loan Amount) x 100

LVR = ($300,000 / $600,000) x 100

Here, your LVR, which is the amount you owe compared to the property's value, is 50%.

Now, let’s say you want to buy another property as an investment but don't have enough cash for the deposit. You can ask your bank to use the equity in your first home to secure a loan to buy the second property.

For instance, if the second property costs $300,000, you might be able to secure a $300,000 loan using your first home as collateral.

After buying the second property, you'll own $900,000 worth of property in total but have $600,000 in debt, which changes your LVR to about 67%.

As you gain more equity in both properties, you can use that value to invest in additional properties, growing your portfolio.

This process of using the equity from multiple properties to back new loans is what we call cross-collateralization.

However, the more properties you cross-collateralize, the harder it might get to borrow more in the future. This is because your debt increases and you may need more than just property equity—like actual savings—to secure further loans.

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Another ratio, similar to LVR, which helps to manage debt, is debt to equity ratio. Read more here: What is the debt-to-equity ratio? How to fix it and secure funding?

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Impact on borrowers

Having cross collateral doesn't affect you much if you keep up with your loan payments.

However, if you default on one loan, you could be considered in default on all loans secured by the same asset. This could lead to the asset being seized, and then lenders might have to battle over who gets what portion of its value.

Is cross-collateralization legal?

Yes, cross-collateralization is generally legal and is a common practice used by banks and credit unions.

However, lenders are required to notify borrowers when cross-collateralization is being applied.

There are some concerns about cross-collateralization.

For instance, it's not approved as a method for DIP (Debtor in Possession) financing under the US Bankruptcy Code, and it may give an unfair advantage to certain creditors over others in the same class.

If you want to avoid cross-collateralization, consider these tips:

• Don’t take out credit cards or unsecured loans from the same lender that issued your car loan.
• Avoid having multiple loans with the bank where your car loan is held.
• Be cautious when borrowing from credit unions, as they often include cross-collateralization clauses in their loan agreements.

Benefits of cross-collateralization

Cross-collateralization can provide several advantages for new property investors, such as:

1. Increases borrowing capacity: This strategy might let you tap into the value of your properties to borrow more, though it really depends on the market conditions.

2. Get extra funds without extra hassle: If you already own properties, you can use their value to get more money without needing to pledge new assets. This is super handy for fixing up your places or buying more properties.

3. Possibly pay less interest: When you lump your properties together as collateral, you might be able to snag a deal with lower interest rates.

4. Keep your cash: Using your property value means you don't have to dip into your savings. This is a great move if you've got lots of assets but not much cash on hand.

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Borrowings cost interest consists of a majority of the loan. Read more about how to master interest rates & borrowing costs for SME success.

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Downsides of cross-collateralization

If you’re considering using cross-collateralization to support your investment strategy, it’s crucial to understand the possible risks and disadvantages associated with this method.

1. Less freedom: This method might tie your hands a bit. You could find yourself limited in how you use your properties, especially if you want to pledge them for other deals.

2. Complicated loan details: Juggling several loans with different rules can get really tricky. You'll need to keep a close eye on payments, rates, and terms for each property.

3. Selling can be tough: If you want to sell a property tied up in this way, it’s often harder. You’ll likely need to sort things out with your lender first to free up the property from the deal.

4. More red tape: With cross-collateralization, your control over your properties isn’t as straightforward. Selling or refinancing might require your lender's nod of approval, complicating things further.

5. Refinancing woes: If you want to switch lenders, it could be harder and pricier with all your properties bundled in one package.

Alternative financing options with easy or no collateral

For businesses that are not comfortable with the risks associated with cross-collateralization, there are alternative financing options available:

1. Invoice financing

With invoice financing, businesses sell their unpaid invoices to a lender at a discount to access quick cash flow. The lender advances a portion of the invoice value and collects payment directly from customers, charging a small fee.

This helps bridge cash flow gaps without additional debt.

2. Unsecured loans

These loans do not require collateral, but they typically come with higher interest rates and stricter eligibility requirements.

They can be a good option for businesses with strong credit histories and solid financials.

3. Revenue-based financing

Revenue-based financing offers non-dilutive capital based on a business's recurring revenue, with repayments tied to monthly earnings.

This flexible option is ideal for businesses that want to grow without incurring traditional debt or sacrificing equity.

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 Discover 8 examples of non-bank credit options + pros and cons.

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Think beyond traditional lending: alternative financing 

Getting any kind of business financing, like credit cards or bank loans, comes with its own set of risks. It's important to understand both the good and the bad of any financing option you're looking into.

A cross-collateral loan might offer lower interest rates, but it also means you could risk losing your assets if you can't pay back the loan.

But financing doesn’t have to be a tightrope walk. There are alternative solutions that offer the flexibility and security you need without the added stress.

Exploring these options can provide the capital your business needs to thrive without the complexities of cross-collateralization.

Ready to explore financing options that align with your business goals? Discover how Stenn can help you find the right financial solution for your needs today.