What Is Cross Collateralization?
Cross collateralization is the act of using an asset that's collateral for an initial loan as collateral for a second loan. If the debtor is unable to make either loan's scheduled repayments on time, the affected lenders can eventually force the liquidation of the asset and use the proceeds for repayment.
Cross collateralization can be applied to various forms of financing, from mortgages to credit cards.
- Cross collateralization involves using an asset that’s already collateral for one loan as collateral for a second loan.
- The loans can be of the same type—a second mortgage is considered cross collateralization—but cross collateralization also includes using an asset, such as a vehicle, to secure another sort of financing, such as a credit card.
- Cross collateralization clauses can easily be overlooked, leaving people unaware of the multiple ways they might lose their property.
How Cross Collateralization Works
Cross collateralization is common in real estate loans. For example, taking out a second mortgage on a property is considered to be a form of cross collateralization. In such a case, the property is used as collateral for the original mortgage. The second mortgage then taps into the equity that the property's owner has accrued for collateral.
There is a reverse circumstance wherein cross collateralization comes into play. Multiple real estate properties could be listed as collateral for one loan, which is typically the case for a blanket mortgage.
The loans involved in cross collateralization don't have to be the same type. Cross collateralization also includes using an asset, such as a vehicle, to secure various other sorts of financing or financing instruments, such as credit cards.
The Hazards of Cross Collateralization
Cross collateralization clauses can easily be overlooked, leaving people unaware of the multiple ways they might lose their property. Financial institutions often cross collateralize property if a customer takes out one of its loans and then follows up with other financing from that same bank. (While they'll do this if everything stays "in-house," there is a reluctance among banks to cross collateralize a piece of property that is already used to secure financing with another institution.)
For example, consumers who obtain financing from a credit union to purchase a vehicle might sign a loan agreement that uses the vehicle as collateral. What the consumer might not be aware of is that the loan agreement may stipulate that the vehicle will also be used as collateral to secure any other loans or credit they take out with that credit union. The lien that is placed on the car from the initial loan would then apply to all other financing accounts the consumer opens with that institution.
This situation could lead to an unfortunate circumstance, in which a consumer who is late on paying a credit card bill—a card issued by the credit union—has their car repossessed, even though they are current on their car loan payments.
Cross Collateralization and Bankruptcy
Consumers who file for bankruptcy while some of their property is tied up in cross collateralization might attempt to enter reaffirmation agreements for all the financing secured by that collateral. They would then continue to make payments on those loans in order to retain possession of the property. Another option is to allow the collateral to be repossessed. The debts that were secured by that collateral would be discharged at the end of the bankruptcy but the property would no longer be in their possession.