Cross-collateralised loan: what is it and how does it work?

Australian property values have soared in recent years, and that’s seen plenty of homeowners enjoy a valuable boost to their home equity. Cross-collateralisation can be one way of putting that equity to work without having to sell your home. But there are pros and cons to weigh up.

The term ‘cross-collateralisation’ doesn’t exactly roll off the tongue. But while it may be a mouthful, the idea behind cross-collateralisation isn’t as complex as it might sound, even if it can still be complex in practice. Let’s break it down.

What is cross collateralisation?

‘Collateral’ simply means the security you put up for a loan. In the case of a home loan, the property you buy generally acts as security, or ‘collateral’ for the loan.

Cross-collateralisation means putting up more than one property as security for a loan (or potentially more than one loan). Why would you do this? It can be a way of putting home equity to work. Peter Corta, a Queensland-based mortgage broker with Aussie, says, “cross-collateralisation is a useful alternative to paying a cash deposit when buying a second or even third property.”

How does cross-collateralisation work?

As a hypothetical example to show how cross-collateralisation can work, Mr Corta says a homeowner may have a house worth $1 million, and a home loan with a balance of $500,000. This brings the value of their home equity to $500,000. That equity can potentially be used to fund another property – in this case we’ll assume an investment property costing $500,000. “Using cross-collateralisation, the homeowner now has combined assets worth $1.5 million and total debts worth $1 million,” explains Mr Corta.

As their equity grows in the second property, the property owner may be able to use that equity to fund another property. In this way, cross-collateralisation has the potential to help homeowners build a property portfolio.

In some cases, homeowners may even be able to borrow all the upfront costs associated with the second property, such as stamp duty, according to Mr Corta. And cross-collateralisation isn’t limited to investing in a rental property. It may also be an option if you want to buy a holiday home.

Is cross-collateralisation legal?

Cross-collateralisation is entirely legal, and Mr Corta says it can potentially be a simpler alternative to taking out multiple loans with different lenders. But that doesn’t mean it will be the most suitable option for every borrower, since it isn’t without its risks and drawbacks.

The pros and cons of cross-collateralisation

To decide if cross-collateralisation is the right strategy for you, it’s important to weigh up its benefits and drawbacks. Here’s a summary of some of the main pros and cons of cross-collateralisation.

Potential advantages

You only have to deal with one lender – cross-collateralisation means you use the same lender to fund all your properties. This can help simplify money matters, potentially making it  easier to manage your account and fees because you have one lender, as opposed to taking out separate home loans with a variety of lenders

You may be able to invest sooner – cross-collateralisation can mean you don’t necessarily need to wait to save up a deposit to buy an investment property, as you can use your existing home or investment property as security.

You can preserve cash savings – by using the equity in your home as security for an investment property loan, you may not need to provide a cash deposit. This can mean you don’t have to dip into personal savings.

Potential drawbacks

All your loans are with one lender – cross-collateralisation is one area where a positive can also be a negative. Having just one lender can help streamline your finances, but if you aren’t careful it can also lock you into a lender with less than competitive interest rates. According to Multifocus Properties and Finance, if you want to refinance further down the track, you may need to have all the cross-collateralised properties valued – a cost the lender is likely to pass on to you – and an unfavourable valuation of just one property has the potential to scupper your refinancing plans altogether.

There can be limits on how much equity you can use – you may have accumulated plenty of equity in your home, but that doesn’t always mean much of it can be used as security for another property. As Mr Corta notes, each lender typically has its own postcode restrictions, which can impact the maximum loan-to-value ratios a borrower can access. For instance, he says, some banks won’t lend more than 60% of the value of an inner-city apartment.

Issues can arise if you want to sell a property – as Momentum Wealth points out, if you want to sell a cross-collateralised property, you are fundamentally altering the agreement you have with your lender. You’re changing the security the lender has, and potentially altering the loan-to-value ratio. This can raise the possibility of the lender asking you to sell other cross-collateralised properties because you no longer meet its lending requirements.

You could be asked to pay lenders mortgage insurance – if cross-collateralisation sees you borrowing a total of more than 80% of your home’s value, the lender will likely ask you to pay lenders mortgage insurance. This may limit how much home equity you can put towards funding an investment property.

What you may want to think about

Some property investors choose to have loans with multiple lenders rather than go through a single lender and cross-collateralise. This is because they may feel going through one lender for their properties gives that lender too much power.

Cross-collateralisation can potentially provide some benefits, but it’s important to carefully weigh up the risks, and to consider seeking financial advice to help determine the loan structure that suits your circumstances or preferences. One way to get started could be to compare investment home loans with Canstar.

Main image source: Andrey_Popov/Shutterstock.com

Original author: Petrina Berry.