Sometimes, a piece of collateral is valuable enough to secure more than one loan. This process is known as cross-collateralization. It is advantageous in that you don't have to encumber multiple pieces of collateral. However, you are also in a situation where, when you pay one loan off, your asset is still tied up with another loan.
The main reason you would cross-collateralize is that you need multiple loans, and you have a valuable property that can secure those loans. This is common in business loans. For example, suppose you want a $30,000 term loan to make repairs to your property and a $50,000 line of credit to keep in case you need sudden funds. You have a property worth $300,000. The $80,000 combined balance has a low loan-to-value, or LTV, of 27 percent, so you can easily qualify for both.
Securing the Loan
Once approved, you attend a closing and sign the appropriate loan documents. Continuing our earlier example, you would sign two individual promissory notes, one for $30,000 and one for $50,000. You would do it this way because each loan has its own unique terms. You would then sign the mortgage, which would be in the amount of $80,000. The mortgage would reference both notes in the body of the document, tying each loan to the single mortgage. The lender would record this mortgage with the county clerk, solidifying its interest in the property.
Cross-collateralizing is convenient in some ways, but detrimental in others. For example, if your financial situation goes downhill and you stop paying on one loan, your property is still at risk. Even though the other loan is current, the lender can still foreclose because you’ve defaulted on that obligation. If each loan were secured by separate collateral, you could end up losing the property securing the delinquent loan, but would still keep the property securing the current one.
In addition to delinquency, there are other issues that can pop up with regard to the collateral. If you want to sell or otherwise release the property, you have to pay off both loans securing it. If you still need one -- the line of credit for example -- you would need to provide alternate collateral in order to keep it. Since the lender will not agree to release the property until you provide new collateral, you may end up in a position where you’re forced to pay the loan and then reapply once you’ve purchased a new property valuable enough to secure the loan.
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