It has been a long time since our last Everyday Property Foundation post where we talked about Positive Cashflow. We’re back to continue our series and this time, we are discussing Cross Collateralisation.
One of the financing options that you can use to be able to purchase another property to add to your portfolio is cross collateralisation. Now this structure elicits both positive and negative reactions from property investors. Here we will enumerate the pros and cons to this concept to give you an idea whether this strategy is something that might work for you or whether cross collateralisation is something you want to avoid.
What is Cross Collateralisation
Simply put, cross collateralisation is a form of loan structuring where more than one property is used to secure a loan. So the borrower uses another property (aside from the one that is being loaned for) as a security for the lender. Many of us have cross collateralised loans and aren’t even aware of it.
To give you an idea how cross collateralisation works, consider the example below:
A borrower who owns a property worth $500k and owes $200k on the loan wants to buy another property worth $300k. The borrower decides to use his existing property with $200k of loan balance as an additional collateral, or security, to purchase the new property.
Cross collateralisation is an option for those who want to purchase another property but may not have enough funds to make the purchase independently of using additional security. The borrower may tap into the equity from an existing property to make the purchase possible from their perspective and desirable for the lender. So the advantage here is that it gives the borrowers an option not to use their own cash to acquire the second property.
Many borrowers are aiming for the magical 80% LVR to avoid paying mortgage insurance and by using the equity from another property they can avoid this cost. Lenders mortgage insurance can be a pretty hefty sum and offers no protection to the borrower, so you can see why investors would like to avoid it.
Another situation wherein a borrower may use this strategy is when his/her credit rating is not as strong as what a bank would require. Cross collateralising another property aside from the target purchase gives the lender a security, lessening the risk for them to grant the loan to a borrower who has an otherwise weak credit rating.
Having another property cross collateralised may also earn the borrower interest rate discounts from lenders, and that is definitely an advantage.
Consolidating your existing loan with another loan from the new purchase would also mean less paperwork since you will only be dealing with one lender.
Banks love cross collateralisation and you can understand why. They have access to and control over more of your portfolio, reducing risk to themselves. Let’s take a look at the disadvantages of this approach.
The biggest disadvantage of going this route is obviously the risk of losing two or more properties should there be a default in the agreement. Aside from this obvious downside, let’s discuss the other reasons why this strategy is frowned upon by some property investors.
Since the lender has your portfolio of properties, it gives them control over the properties cross collateralised to them. In the event that you need to sell one of the properties that is currently involved in a cross securitisation setup, the lender may dictate the terms or conditions to the sale and limit the ways in which any sale proceeds are used.
If a property is sold, the lender might require the borrower to use the money from that sale to pay down the loans of other cross securitised properties and reduce the amount borrowed. This meant you won’t be able to use the money from the property sold at your own discretion.
Just as having one lender makes paperwork less of a hassle, having a cross collateralised portfolio can increase complexity upon purchase or sale of a property as each property in the arrangement will most likely need to be re-valued. This can increase both time and cost.
Having multiple properties used as security can also enable the banks to control the type of loan used for a purchase. A bank may determine that you use a principal and interest loan, for example, where you want to use an interest only loan.
Changing lenders can also become a difficult process when multiple properties are involved with the one lender in this manner.
The other main disadvantage lies in being able to access equity in a property. Where properties are cross collateralised the overall equity gain or loss is measured as a sum each of the properties involved.
So you may experience capital growth in one property and wish to access that equity; however, another property being used as security may have dropped in value and therefore the gain that you experienced in one property is essentially negated by the loss in another.
What to do?
Getting started in investing it seems an easy option to utilise the benefits of cross collateralisation to enable you to purchase multiple properties faster and to avoid paying lenders mortgage insurance.
This approach may work just fine for one or two properties, perhaps even three. In my experience, however, it’s once you start to really develop a portfolio beyond just a few properties that you start to come across the disadvantages of cross collateralisation and they start to have a capacity of limiting your portfolio growth.
Undoing a cross collateralised portfolio, where there are several properties involved, can take some time and can also take some money. So my advice, when it comes to cross collateralisation, is this:
- Find a mortgage broker who really understands not only property investing, but building a portfolio of property, rather than just one or two properties.
- Speak to your mortgage broker to understand how your loans are structured to ensure that the structure works for this loan as well as for the future.
- Don’t be afraid of lender’s mortgage insurance, it can be a good business decision in many circumstances.
- Avoid cross collateralisation where possible, or at the very least, make sure you understand the pros and cons of the situation and make decisions that will provide you the best outcome for your investing.