Cross Collateralization Explained
Cross collateralization is the process of using collateral from one loan as the security for an additional loan(s). There are very few benefits of cross collateralization for the customer, and it's often a misused substitute for multiple standalone loans due to lack-of-understanding. Always speak to a Mortgage Broker about your individual situation.
Cross collateralization can be used almost any time two properties are involved and the equity in one is required to refinance/purchase a second or third property. A common situation where cross collateralization occurs is when a home owner wants to use equity in their owner-occupied house to purchase an investment property. Using cross collateralization, the loan setup for this scenario will look like this:
What's wrong with Cross Collateralization?
The above setup can have no adverse effects or complications, but what happens when you want to sell or refinance one of your properties? When this happens, the bank will usually require valuations on both properties (usually at the customer’s expense), and a significant drop in the value of one property can prevent the sale of the other. Because both properties are tied together, the bank has the right to ensure the overall Loan to Value Ratio (LVR) stays below 90%, which means the total loan amount cannot exceed 90% of the combined property values.
Before the bank will discharge either mortgage, if the post-sale LVR is higher than the pre-sale (when the properties were cross collateralized) LVR, the bank will usually want to re-asses your situation and risk factors, meaning you might have to provide financial and personal documents to prove your situation is stable.
If the sale or refinance is approved by the bank, but the post-sale LVR is above 80%, the bank will require the borrower to pay an LMI (Lender's Mortgage Insurance) premium. This can amount to tens of thousands of dollars in some cases.
What are the Advantages of Cross Collateralization?
The only benefits of cross collateralization for the customer are:
- Ease of transaction: the loan setup can be completed in one simple transaction.
- Loan establishment fees: these can be minimized through the process.
Should I Cross Collateralize?
In the majority of cases, the answer is no. The potential additional fees and complications are seldom worth the benefits. Cross collateralization can be a worthwhile approach if the LVR is very low, or if you can be certain they will not be selling or refinancing either property (or using them to guarantee other loans) in the short-to-medium term. Even when confidence is high, a drop in value of either properties can make your situation far more complicated than it should have been.
So why do people do it?
It’s much simpler to setup a loan this way, as it saves time writing, submitting, assessing, and signing multiple loan applications. It is also often easier for a borrower to understand, when compared to the alternative. Certain banks are also known to encourage cross collateralization as it lowers the bank's exposure to risk.
How to avoid Cross Collateralization?
The alternate method is setting up multiple stand-alone loans, meaning only one security is used per loan account. The same example from before might look like this, when set up using stand-alone loans:
Note: The owner-occupied property is security for one loan, with two splits, one of which must be investment. The loan type must legally be defined by the purpose of the loan, not the security. Because there is $100,000 equity in the owner-occupied property to purchase the investment property, it must be setup as an investment split. This is also the reason we need to setup 3 loan accounts/splits.
As you can see here, the overall loan amount, LVR, and security value are the same as in the first scenario, yet the loans are setup completely different. The major difference is that no loan is secured by multiple properties, meaning you can sell and refinance each property independently without the bank requesting additional valuations and assessments.
Cross Collateralization and Lender’s Mortgage Insurance (LMI)
Another point to consider, is that setting up a loan above 80% LVR (less than 20% deposit/equity) generally requires the borrower to pay Lender's Mortgage Insurance, which is usually more expensive when properties are cross collateralized. When cross collateralized, the Mortgage Insurer will assess the risk by looking at the overall LVR and the total security value (i.e. 'their exposure') i.e. $900,000 – which can make very large LMI premiums. By using stand-alone loans, the LVR of one loan can be manipulated to 80%, whilst increasing the LVR of the other: the Mortgage Insurer is now only exposed to one security/loan worth $500,000, making the premium much lower (despite the higher LVR). Unfortunately many consumers and professionals are unaware of this, and the customer will, in some cases, pay $5,000+ more than they needed to on their LMI premium.
It is possible for cross collateralization to be beneficial for the borrower, but in most cases it is not worth the risk. When setting up your loans, please pay close attention. It is always recommended you speak to a professional about your situation, but also ensure you understand the reason behind their recommendations. Be sure to ask questions about anything you don't understand, and don't hesitate to get a second opinion if anything seems amiss.
If you have any questions about cross collateralization, please send me an email on firstname.lastname@example.org or call me on 07 3354 4576 and I'll be happy to answer your questions free of charge.