Cross collateralization happens when you use collateral for one loan on another loan. This can happen in a number of different situations, but a common example is taking out a second mortgage on your home.
Let’s take a look at cross collateralization, how it works, and whether it’s worth using in your situation.
Definition and Examples of Cross Collateralization
The most important aspect of cross collateralization is that you are using property with an existing loan as collateral for an additional loan. This can be done intentionally, but in some situations, cross collateralization may be included in a contract without your realization. Read your loan contracts carefully in search of this term.
- Alternate name: Cross collateral
Depending on your bank, you may encounter a cross collateralization clause when taking out a loan. Axos Bank, for example, offers cross collaterals for certain loans up to $25 million. Key Bank includes a cross collateralization clause in the application for its Key2Business program. Such clauses can state that the asset you buy with your loan is collateral for the loan itself and that the asset may also be used as collateral for any future loans you take out with that same bank.
A second mortgage on your home is another fairly common example of cross collateralization.
How Cross Collateralization Works
Let’s say you bought your home five years ago for $300,000. You saved up enough to put down a 20% down payment of $60,000, which means your total loan amount was $240,000. After making payments for a few years, the total amount you owe is down to $200,000. At the same time, the housing market rose, making your home more valuable.
A new appraisal done on your property says your home is now worth $350,000. This is great news for your family, since your children have been begging you to put in a pool for the last three years.
To finance the pool, you and your spouse are considering getting a second mortgage on your property. This can come in two forms: a home equity loan or a home equity line of credit (HELOC). Both of these options will use your home (which still has a mortgage on it) as collateral in case you default on payments. This is cross collateralization.
In the case of a second home loan, you’ll be limited in how much equity you can withdraw from your property. This will depend on your credit score, although most lenders require you to keep some equity in your property. For instance, Discover Home Loans generally requires your first and second mortgages to total no more than 90% of your home’s appraised market value.
Cross collateralization can be a useful tool, but be aware that defaulting on one or both of your loans can force you to liquidate your property to pay your debt.
Another example of cross collateralization may exist during some dealings with your financial institution. Say that you use your credit union to purchase a new car. As part of the contract, the credit union states the car can be used for collateral for any future debt, including unsecured loans and credit cards.
Several years later, you’ve already paid off the car but have been laid off. It’s been a few months since you’ve been able to make any credit card payments. Since the car has been used as cross collateral, the credit union can still force you to sell it to satisfy your credit card debt—even though you’ve paid off the car.
Is Cross Collateralization Worth It?
The answer to this question depends on your personal situation. Using your home’s equity to get a second mortgage is a common example of cross collateralization. This can be a good way to withdraw money from your property without having to sell it.
However, there are risks involved with cross collateralization. If you’re not careful about your payments, you may be forced to liquidate your home, vehicle, or other property to pay off one or both of your loans. You’ll also want to consider the cost of interest in any additional loans you take out.
- Cross collateralization is the act of using property with an existing loan as collateral for another loan.
- A second mortgage on a home is a common example of cross collateralization.
- Cross collateralization can be a good way of maximizing the value of your property, but you should weigh this against the risks.
- Failing to pay one or both loans on your property can force you to sell your collateral to satisfy your debt.