Firstly, let’s take a look at what is collateralisation. Collateralisation involves a borrower pledging an asset to a lender as security for repayment of a loan.
This means if the borrower fails to pay the debt or can’t make their repayments, then the lender has the right to take the asset as compensation.
So, what is cross collateralisation?
Cross collateralisation, or cross collateralised loans, means more than one property is used to secure a loan or a number of loans. As a result, you could lose more than one property if you were to default on your mortgage repayments, therefore it is important for property investors to understand the benefits and risks that come with this loan structure.
Here’s a basic example of how cross collateralisation works. Say you want to buy an investment property and currently have a house worth $600,000 with no home loan. This means you would have $600,000 worth of equity.
You then decide to buy a $500,000 investment property but you don’t have the $100,000 for a 20% deposit. So, you use the equity in your home as security for the $100,000 deposit and your investment property as security for the $400,000 loan.
This means you have a $500,000 loan with the one lender that is secured by two assets, your home and the investment property. This is how cross collateralisation works.
To put it another way, you have a $500,000 loan secured by $1.1 million worth of property, which equates to a favourable loan to value ratio (LVR) of about 45%, with a caveat being that you could lose both your properties if you fail to meet your loan repayments.
What are the possible benefits?
Cross collateralisation allows you to use equity in one property as a deposit for another investment property, however it is important to weigh up the risks associated with this approach. Here are some of the potential benefits:
- You don’t necessarily need to wait to save up a deposit for an investment property
- You can unlock the equity you hold in your home or investment properties should you wish to grow your portfolio.
- You may be able to negotiate favourable loan terms, such as a lower interest rate, when you have a higher loan amount with a single lender
- You may find it easier to manage your account and fees because you have one lender, as opposed to if you were to take out two separate loans with different lenders
- You may be able to lower your loan to value ratio (LVR) by offering a second property as security on the loan which may increase your chances of getting a loan
What are the drawbacks?
It’s important to understand the risks you take on as a borrower when deciding on any loan structure. When it comes to cross collateralisation, you are tying yourself to one lender and with that can come some drawbacks, including the following:
- You may find you have less control over your property, for example if you decide to sell one of your properties, the lender may dictate that the proceeds go towards paying down your mortgage
- You may find it difficult to refinance or switch to another lender
- You may find the establishment fees are higher than a stand-alone home loan
- You may have to pay Lender’s Mortgage Insurance if there isn’t sufficient equity over all the properties
- Your lender could end up holding more security than is necessary for your loan
- You may find your borrowing power is restricted due to sticking to one lender and cross collateralising
- You may find restrictions on the type of loan you can apply for. For example, the lender may require you to take out a principal and interest loan which can be a problem for investors who may want to free up their cash flow with an interest-only loan
- If you have cash flow problems and can’t meet your repayments, your lender can take possession of all properties used to secure the loan
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 feel going through one lender for their properties gives that lender too much power.
Cross collateralisation can provide some benefits, however it’s important for you to weigh up the risks and even consider seeking financial advice to help determine what loan structure suits your circumstances or preferences.
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