Cross-collateralization: Overview, Benefits & Risks

In today’s world, your average person is likely to take out multiple loans in order to live a comfortable life. Cars, houses, and other big-ticket items are just too expensive for most people to pay for out of pocket. Oftentimes, when a loan is taken out, collateral is needed to secure the debt. In these cases, borrowers can take advantage of cross-collateralization. In addition, many credit unions require cross-collateralization when a borrower takes out two or more loan products (ex: car loan and credit card).

What Is Cross-Collateralization?

Cross-collateralization is when the same asset is used as collateral for more than one loan. It can be used for:

• Mortgages
• Home equity loans
• Auto loans
• Personal loans
• Commercial real estate loans
• Business loans

Cross-collateralization makes it possible for borrowers to receive loans when they would otherwise be unable to get a loan. 

Risks of Cross-Collateralization

All loans include some risk to the borrower. However, there are some risks which are specific to cross-collateralization. They can include:

• Defaulting on Multiple Loans: if you default on one loan that is cross-collateralized, you are essentially defaulting on all loans secured by the same collateral This means that the lender can potentially seize all assets pledged as security across all those loans to recoup their losses. Put in simple terms, a default on one loan triggers a default on all cross-collateralized loans.

• Loss of Assets: When defaulting on a cross-collaterized loan, the lender is likely to seize the assets used as collateral. If you have your car and home cross-collaterilized, a default could leave you without both, having a seriously negative impact on your quality of life.

• Difficulty Refinancing: Under normal circumstances, refinancing is a relatively simple and straightforward process. This is not the case with cross-collaterilization. It can be expensive and complicated to refinance a loan if you use the same asset as collateral for multiple loans. 

• Limited Ability to Sell Assets: You may not be allowed to trade in a car or sell a property if it’s being used as collateral for another loan. At the very least, it will make the process much more difficult.

As you can see, even though cross-collaterilization can be a useful tool, making use of it comes with a significant amount of risk.  

Mortgage Cross-Collateralization

Mortgage cross-collateralization is when you use your home as collateral for multiple loans. Most often, the home will be used as collateral for a mortgage (obviously) and a home equity loan at the same time. 

The benefits of mortgage cross-collateralization include:

• It can make it easier to receive a home equity loan.
• It can help you receive much needed funds when needed by leveraging an asset you already have.
• It can provide a better interest rate than if you were to take out a loan with no collateral. 

Of course, there are also risks to consider. These can include:

• The difficulty of making payments on two loans at the same time.
• Defaulting on either loan can result in the lender seizing your house, leaving you in a very vulnerable situation.
• It can make the sale of a home more complicated.

A careful analysis of the benefits and risks should be undertaken before deciding whether or not to pursue mortgage cross-collateralization.

How Does Cross-Collateralization Affect Bankruptcy?

Bankruptcy is always a complicated process. However, it can become significantly more complicated when cross-collateralization is involved. This is because cross-collateralization can make what would normally be considered unsecured debt, like debt from a credit card, into secured debt. This usually leaves the debtor with two options. Option one is that they reaffirm the debt, agreeing to continue paying the loan instead of having it discharged, which is usually the main goal of bankruptcy. The second option is to give the asset used as collateral to the lender in order to discharge the debt. Of course, either option prevents the liquidation of the asset. This is especially an issue if you are filing chapter 7 bankruptcy, where the entire goal is to liquidate assets in order to pay creditors. 

How to Handle Cross-Collateralized Debts

If payments cannot be made and you are in danger of defaulting, cross-collateralized debts are often best handled by filing for chapter 13 bankruptcy. Chapter 13 involves creating a debt repayment plan that reorganizes cash flow and provides relief from creditors. The repayment plan usually spans three to five years and can involve repaying a percentage of the debt or all of it. Using an experienced bankruptcy attorney, you can likely keep the asset that was used to obtain the cross-colllateralized loans. This can be extremely helpful if the asset is your car or home, both things needed to function in your day-to-day life. 

Finally, in many Chapter 13 bankruptcy cases, a properly prepared bankruptcy plan can break the cross-collateralization and break the loans back into a secured portion and an unsecured portion.   This can save the borrower many thousands of dollars and save the assets from repossession or sale.