What is cross collateralization?
Cross collateralization involves using an asset provided as collateral for a loan for securing a second or multiple loans.
Consider a commercial real estate loan secured by a piece of property. The borrower can cross collateralize the same asset to take a second loan from the same lender. If the borrower fails to make loan repayments for the first or second real estate loans, the lender can seize the property and sell it to recover its dues.
Cross collateralization can also refer to a single loan secured by multiple properties.
What is a cross-collateral loan?
A cross-collateral loan uses a single property to secure two or more loans. A borrower can opt for such an arrangement for several reasons. First, borrowers do not need to provide additional assets as security to lenders when they want to add on to their existing debt. Using the same property is simpler and involves less paperwork.
Second, when the same lender is providing the loan, the cost involved in mortgaging the asset has already been incurred, making the loan process more straightforward and economical. There is a third significant benefit for borrowers. As the level of risk in the loan is reduced, lenders could lower the interest rate.
Cross collateralization serves lenders well, too. The lender gains a greater hold over the borrower by mortgaging the same property to secure multiple loans. For this reason, the cross-collateralization clause in a loan agreement is also referred to as a dragnet clause.
A personal loan can also be cross collateralized. For example, an individual can buy a new car with borrowed funds. The lender advancing the auto loan would use the car as collateral. Subsequently, the borrower may require funds for, say, home repairs. He can take a personal loan to meet this requirement. The car could serve as collateral for this personal loan as well.
Why is cross collateralization used?
Both investors and financial institutions use cross collateralization extensively. Borrowers find it convenient, as it helps them secure additional funding. At the same time, banks and other lenders are only too glad to provide a cross collateralization loan backed by a real asset rather than extend an unsecured loan.
Here are some of the specific reasons that cross collateral loans are popular in commercial real estate lending:
1. Reducing lender risk
When borrowers seek additional funding, lenders can be open to the cross collateralization of the same asset that was used to secure the initial loan. In the event the borrower defaults on either loan, the lender can sell the asset to recover the amount advanced.
2. Qualifying for larger loans or better terms
Cross collateralization works well for borrowers who require a new loan. They can use the existing equity in an asset to secure the funds they need. In many situations, offering the same property already provided as security for a loan is the only option open to the borrower. At other times, lenders may insist on a cross collateral loan structure to reduce the level of risk in the loan.
Another advantage for borrowers is that the bank or financial institution advancing the loan can agree to lower the interest rate because the loan is secured.
3. Using existing equity for new acquisitions
Cross collateral loans, which involve securing multiple loans with the same property, have two other significant benefits for the borrower.
- If the loans are from the same lender, funding is usually quick. The cross collateralization agreement can be executed speedily, as the loan terms and conditions are already in place.
- The loan fees involved can be lower as well.
How does cross collateralization work: Example
The following example will clarify how a cross collateralization agreement works:
Consider an investor (Investor A) who wants to purchase a commercial property valued at $1 million. The bank financing the transaction requires a down payment of 30% or $300,000. However, Investor A has only $200,000 in cash available.
How will Investor A arrange the remaining $100,000?
One option can be to enter into a cross collateralization agreement and mortgage Investor A’s existing property, valued at $2 million. This property is mortgaged to the same bank. The outstanding loan amount on this property is only $500,000. The bank is happy to accept the cross collateralization arrangement and advance $800,000 for the new property. (The remaining $200,000 is the down payment made by Investor A.)
Here’s the same example in tabular form:
How cross collateralization works: An example
| Loan application to the bank without cross collateralization | Loan application to the bank with cross collateralization | ||
| Value of new property | $1 million | Value of new property | $1 million |
| 30% down payment is required by the bank | $300,000 | 20% down payment by investor | $200,000 |
| Cash available with the investor | $200,000 | Cross collateralization agreement entered | Existing property valued at $2 million. The outstanding loan amount on this property is $500,000. |
| Transaction status | Bank does not extend finance | Transaction | The bank agrees to finance the new property |
Benefits of cross collateralization
Cross collateralization can provide investors with a range of benefits:
- Increased borrowing capacity: Investors can use the same property to secure multiple debts. As seen in the immediately preceding section of this post, a cross collateralization arrangement can be the deciding factor in getting the bank to agree to extend finance for a new property investment.
- Simplified collateral management: Providing the same asset as security for multiple loans can simplify the documentation process. However, borrowers should remember that when using an existing security instrument as security for an additional loan, appropriate changes may be necessary. It should be ensured that the security instrument references the new loan.
- Better loan terms: A cross collateralized loan can get borrowers favorable terms in the form of reduced fees.
- Access to additional funds: A cross collateral loan allows borrowers to leverage the value of their existing collateral to raise additional funds.
- Potential for lower interest rates: A cross collateralized loan lowers the lender’s risk, allowing the borrower to negotiate a lower interest rate.
- ?Cash savings: If the lender agrees to reduce the interest rate on the loan, the investor will have a lower borrowing cost, resulting in additional cash savings.
Risks of cross collateralization
Cross collateralization has downsides as well. Here are some that investors need to watch out for:
- Risk of overleveraging: Cross collateralization can help investors borrow additional funds and invest in new properties. However, in a market downturn, this advantage can quickly become a disadvantage. As property prices drop, lenders can seize assets if the borrower defaults on payments.
- Complexity in foreclosure: Consider a situation where a borrower has provided two properties as collateral for one loan. If the loan goes into foreclosure and cannot be paid off by selling only one property, the borrower may lose both properties.
- Reduced flexibility: Using the same property for multiple loans can lead to complications in documentation if one of the loans is to be repaid.
- Challenges selling: Selling the mortgaged asset can be challenging as the investor may be required to repay all the loans that are secured by that asset.
- Difficulty refinancing: Changing lenders can be complicated and expensive if only one of the loans is to be refinanced. Consider a situation where an investor has secured three loans using the same asset. If one of these loans is to be refinanced, it can involve revaluing the property and involving the other lender(s).
Alternatives to a cross-collateral loan
The cross collateralization clause in a loan agreement is also known as the dragnet clause. This clause traps the borrower if there is a default in any of the loans secured by a mortgage on the property. Consequently, failure to repay one loan may trigger the sale of the mortgaged property that serves as security for several other loans.
An investor who wants to avoid facing the situation described above would do well to follow a policy of securing each loan with a different asset. While this may curtail the investor’s borrowing capacity, it can be a far more conservative commercial real estate investing approach to follow.
The bottom line
Cross collateralization secures two or more loans using the same property. Investors can use cross collateralization to raise additional funds for new investments. However, this strategy can lead to complications if the asset is to be sold or one of the loans is refinanced. It could also backfire if there is a market downturn. Conservative investors may want to play it safe and mortgage a different property for each loan.
